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One of the things I often see is people is holding onto losers. It’s understandable in a sense because it can feel like the losses are not real if we don’t recognize them.

But there are real costs to holding onto an underperforming investment. The most important of these is that we prevent ourselves from deploying that capital in something else that might do better. In other words, we might feel better waiting for a stock to go back to what we paid for it, but that might be a long wait. And in the meantime, we might have missed out on something else that could have done a lot better. Besides that, there are significant tax advantages to realizing losses in a taxable account.

At the core, I think, is accepting a certain amount of humility when it comes to investing. It is painful to recognize a loss because it hurts our pride. We feel like we were wrong. And if only it comes back to the price we paid, then maybe we weren’t wrong after all.

But I don’t look at it that way. Investing is always about probability and there is always a good chance of being wrong. There’s no guru, no matter how brilliant, who is right all the time. There might be some that are right more often than average, and that allows them to do well. But even so, they are still wrong much of the time. By accepting that and moving on when we’re wrong, we have the potential to improve the quality of our investments over time.

So how do we know when we’re wrong and it’s time to move on?

I would not follow hard-and-fast rules such as a fixed percentage or a stop-loss rule. Everything is about context and using judgment. There is truth to the other side of the coin: if a company is a good value at $20, it might be a better value at $10. This, of course, assumes that it’s just as good a company as we thought it was originally.

But that decline is a signal that maybe, just maybe, we got it wrong or that the business deteriorated. At a minimum, it’s time to reevaluate the business fresh and consider whether we would buy it now if we did not already own it. But this is difficult as we have a habit of changing our stories to justify holding onto a stock we don’t want to sell for emotional reasons.

If there is any doubt, I would err on the side of selling the loser and moving on. The fact is that there are many good companies out there and perhaps dozens of great companies. Why miss out on the opportunity to own one of them by having money tied up in a company that has disappointed?

Personally, I believe this habit can save investors from having small mistakes become bigger mistakes and opens the door to better opportunities.
 

Key Wealth Principles

• A foundation of good habits is more important than fancy techniques
• Invest in quality businesses at an attractive price
• Build a portfolio of good businesses in different industries
• Maintain appropriate reserves and income sources
• Consider your financial circumstances, goals, and risk exposure
   

Last Month’s Winners and Losers

Last month favored better quality companies—large cap stocks, profitable companies, capital efficient companies, and companies with less debt. Tech stocks continued to shine with strong earnings reports.

Losers for the month were riskier companies, such as small cap, unprofitable businesses, highly levered businesses, regional banks, and theme stocks. Dividend stocks also underperformed, as did Chinese stocks.
 

Stocks

Most areas of the market were down, with underperformance among small caps and dividend stocks. However, strength among the Big Tech companies and other large, profitable companies drove the S&P 500 to a positive return last month.

Looking at the characteristics of different equity markets, they seem appealing to long-term investors. Earnings yields average around 5-6%, depending on which segment of the market you’re looking at, and earnings growth expectations range from 7% to 13%, depending on the segment. When I look at individual stocks, I do not have a problem finding ones I think are appealing from a value perspective.

* “Earnings yield” is an investor’s share of earnings for every dollar invested (i.e., earnings per share / price per share). It’s the same as the more famous Price / Earnings (P/E) ratio, but expressed as a yield rather than as a multiple. I use it to compare stocks more clearly with bonds and other asset classes.“Equity Risk Premium” equals the Earnings Yield minus the 10-year Treasury Inflation Protected Securities yield.
 

Income Investing

Core inflation continues to come in at the 3-4% level and has not really improved over the last twelve months. Given the Federal Reserve’s target of 2% inflation, this implies that it will not ease rates soon. For some reason, this surprised the market and drove negative performance among interest-sensitive sectors when the Federal Reserve suggested this. However, it really should not have been a surprise given the lack of evidence for inflation coming in further.

I continue to believe that long-term interest rates are not particularly attractive given persistent inflation. For that reason, I am keeping my eye on short term instruments of less than one year maturity and dividend stocks that have the potential to increase dividends faster than inflation over time.

* Implied inflation expectations are derived from taking the 10-Year Treasury rate and subtracting the 10-Year Treasury Inflation Protected Securities (TIPS) rate. For example, if the yield on 10-year treasuries is 2.8% and the yield on 10-year TIPS is 0.4%, they are roughly equivalent investments if inflation comes in at the difference (2.8% - 0.4% = 2.4%).
 

The Long View

For the last 20, 30, and 100 years, stocks have averaged around an 8-10% return, driven by dividend yield, reinvestment of earnings, and earnings growth. Long-term bonds have yielded about 5% on average over the last century while inflation has been about 3%.

Throughout this period, there have been major upheavals, such as the Great Depression, World War II, The Korean War, The Vietnam War, dropping the gold standard, 1970s high inflation, 1987’s Black Monday Crash, the Dot.com bust, the 9/11 terror attacks, the Global Financial Crisis, and the Covid Crash, among others.

These events led to severe market downturns about once every decade, with a median price decline of 33% and a median time to recover back to the previous high of 3.5 years. If we were to include dividends, the recovery to previous highs is actually a little faster. *

Meanwhile, a 3% inflation rate results in a 59% decline in the value of a dollar over 30 years. Meaning that people who retire at 60 years old on a fixed income face a high risk of a lower quality of life as they get further into retirement. *

* Source: Morningstar Direct via cfainstitute.org, FactSet. Past performance is not necessarily indicative of future performance. Depreciation of the dollar: $1 / (1 + 3%)^30 = $0.41 real value 30 years later.
 

Market Outlook

Now I’ll put on my “Nostradamus Hat” and make some predictions, for whatever they’re worth:

• Inflation will average 2-4% over the next 10 years.
• Interest rates will fall in the 3-5% range for 10yr Treasuries over the next several years, in line with inflation and historical experience.
• The economy will grow 2-3% in real terms over the next several years, though we will probably slip into a recession this year.
• Stocks will average an 8-10% return over the next 10+ years. After subtracting inflation, this will translate into about a 5% real return. There is likely to be at least one big decline every decade or so.

From the standpoint of where you and your family will be in 30 years, none of this matters. What matters is finding good quality investments that are likely to grow over the decades. For this reason, I largely ignore my own general market forecast and invest whenever I find a business that I am confident in and that trades at an attractive valuation.

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