The Art of Selling a Losing Position

Investors and traders inevitably will have losing positions, which can create a psychological struggle as they wrestle with whether to buy more, hold on, or sell at a loss. The decision can sometimes feel Shakespearean—it'll end in tragedy, where the position swiftly rebounds after being sold, or a comedy, where it takes a precipitous dive once sold. At these times, the investment management process transcends pure logic, becoming as much an art as it is a science.

The art of selling a losing position is a critical skill that separates seasoned investors from novices. It involves a balance of analytical thinking, emotional discipline, and strategic foresight. Knowing when and how to exit a failing investment can be as important as identifying winning prospects. As legendary investor Peter Lynch once said, "Selling your winners and holding your losers is like cutting the flowers and watering the weeds." The only way to get the weeds out is to pull them from the root before they threaten the whole garden—which means selling off nonperforming assets before their losses overtake your whole portfolio.

By mastering the art of selling losing positions, you can protect your capital, improve overall returns, and develop a more resilient portfolio. Not convinced? Let's go through the 10 reasons you should exit bad positions.

10 Reasons To Sell a Losing Position

There are many compelling reasons to sell a losing position. Here are 10, with further explanations in the sections to follow:

1. You need to protect your initial investment: Preserving capital is crucial for some—especially those needing the funds within the short term—and selling the losing position can prevent further losses.
2. Managing risk: Exiting the losing position helps to limit exposure to increasing risks and maintains the desired risk profile for traders and investors.
3. Market conditions have changed: Shifts in the broad market or specific industries can lead you to sell a position unlikely to recover in the new environment.
4. Sticking to your game plan: If the losing position no longer fits your overall investment strategy, you can sell it for one that better aligns with your investment goals.
5. Fundamental analysis: When the underlying fundamentals of an investment worsen, it's a sign that the original reason for buying it is no longer valid, warranting a sale.
6. Technical analysis: Technical indicators often help determine when to buy an asset and when to cut your losses.
7. To pay less in taxes: Selling a losing position can help offset gains elsewhere in your portfolio, reducing your overall tax liability.
8. Recognizing and overcoming your own mental blind spots: You might recognize and overcome cognitive biases like the endowment effect or sunk cost fallacy that keep you in a losing position.
9. Ensuring you can easily sell when needed: If the position becomes increasingly illiquid or you need the capital, selling the position now can help you avoid the liquidity situation worsening over time.
10. You found something better: Holding onto losing positions while avoiding reallocating capital to more profitable opportunities means falling prey to opportunity costs.

1. Protecting Your Initial Investment

Capital preservation is when you focus on protecting your initial funds from significant losses. This approach works in volatile or declining markets with a high risk of further losses. Selling a losing position allows traders and investors to limit losses and preserve the remaining capital, which can then be reinvested into other instruments.

This reason is particularly relevant for conservative investors, like those nearing retirement or with a short investment horizon who can't wait for a potential recovery. Below are different portfolio types, each with specific needs for capital preservation.

2. Managing Risk

Risk management involves identifying, analyzing, and mitigating the probability of loss. One way to manage risk is to develop a plan for when to sell a losing position to prevent minor losses from escalating into significant, potentially portfolio-damaging losses.

When you sell an underperforming asset, you limit further declines, rebalance your portfolio, and keep your holdings aligned with your long-term financial goals. You can also cut your concentration risk, avoid excessive volatility, and preserve capital for other investments.

3. The Market Has Shifted

Changing market conditions can alter the performance of investments, often turning previously promising positions into losing ones. Economic downturns, rising interest rates, industry disruptions, geopolitical risks, and shifts in market sentiment can all contribute to increased risks or diminished recovery prospects.

Selling a losing position in response to these changes is a proactive way to manage risk, preserve capital, and keep your holdings aligned with your investment strategy. By evaluating macroeconomic indicators, monitoring industry trends, and reassessing company fundamentals, you can better identify when to exit a position and avoid further losses.

4. Sticking To Your Game Plan

Selling a losing position is a good strategic move when an investment no longer aligns with your overall investment strategy. Whether due to changes in financial goals, risk tolerance, or market conditions, holding onto a position that doesn't fit your investment strategy can slow your progress toward your goals, increase risk, and incur opportunity costs.

By reassessing the investment's fit with your strategy, setting clear exit criteria, and executing the sale with a disciplined approach, you can better ensure that your portfolio remains aligned with your needs.

5. Changes in Fundamental Analysis

Investors use fundamental analysis when they need to sell their losing positions based on deteriorating financial health, shifts in business models, industry challenges, management issues, or overvaluation. When key financial metrics such as revenue growth, profit margins, or return on equity decline, or when a company's strategy heads in the wrong direction, it may be time to sell.

Example Using Fundamental Analysis

Traders and investors screen their positions based on financial metrics such as a company's valuation, profitability, and cash flow. The image below is from TradingView's stock screener for the Russell 2000 Index.

Let's say an investor holds shares in GrafTech International Ltd. (EAF), which has declined by about 75% in the previous year. Reviewing the company's profitability ratios, such as its negative gross and profit margins, as well as its negative return on equity, the investor would be inclined to sell this underperforming position.

While these profitability ratios are not the only fundamentals to consider, they offer clear ways traders and investors use fundamental analytical tools to decide when to exit a losing position.

6. Technical Analysis Indicate a Need To Exit

Technical analysis offers a systematic approach to selling losing positions by focusing on price movements, trends, and market signals. Key indicators such as the breakdown of support levels, trend reversals, bearish chart patterns, declining volume, and overbought or oversold conditions can signal when a security, such as a stock, is likely to continue declining, prompting a sale. By identifying these technical sell signals, traders and investors can make informed decisions to exit positions before losses deepen, ensuring that they protect their capital and maintain alignment with their investment strategy.

Example Using Technical Analysis

Suppose the investor reviewed their EAF holdings using technical analysis. The investor could set up two simple moving averages (SMAs), the 50-SMA and the 200-SMA, to evaluate the stock's trend. In February 2022, a bearish signal emerged when the 50-SMA crossed below the 200-SMA, indicating a potential downtrend. This negative SMA crossover could have served as a warning to sell the losing position of EAF shares.

Since that crossover, EAF's stock price has plummeted by about 95%, underscoring the signals technical analysis can provide about when to sell losing positions.

7. To Lower Your Taxes

Investors and traders use tax-loss harvesting to minimize tax liability by selling losing positions to offset capital gains or reduce ordinary income. This cuts down on the amount of taxes you owe. In addition, it allows you to rebalance your portfolio, aligning it more closely with current market conditions and long-term investment objectives.

8) Recognizing Your Blind Spots

Behavioral biases in investing are cognitive patterns or tendencies that can lead investors to make irrational decisions, often resulting in worse financial outcomes. These biases, such as the endowment effect, loss aversion, and the sunk cost fallacy, cause investors to hold onto losing positions longer than needed or avoid taking necessary risks.

For instance, the endowment effect may lead investors to overvalue an asset simply because they own it, while loss aversion might push them to avoid realizing a loss by selling a declining asset, even when a rational analysis suggests otherwise. The sunk cost fallacy can trap investors into continuing with a losing investment because of the amount of money or time already committed rather than deciding based on the present potential for returns. Recognizing and addressing these biases, including those listed in the table below, is crucial for maintaining a disciplined investment strategy and achieving long-term financial goals. Thus, it's a good reason to exit losing positions.

9. Making Sure You Can Sell When Needed

Another reason to sell a losing position is liquidity. In markets with low liquidity, selling an asset can be challenging since it could mean accepting a significant cut in the sale price. In addition, you might need for other activities and may be reluctant to dispose of your losing positions.

If liquidity in the stock further deteriorates or your need for liquidity increases, the potential for additional losses can increase. Selling a losing position early, while there is still market interest or when you don't need liquidity as much, can help avoid more significant losses, especially in volatile or declining markets.

10. You Found Something Better

Opportunity costs are the potential gains investors miss by keeping their capital tied up in a losing position rather than reallocating their funds to more promising prospects. Holding onto a losing investment can drag down overall portfolio performance and limit your strategic flexibility.

By selling a losing position, you free up capital to invest in assets with higher growth potential, enhancing overall returns and keeping your portfolio better aligned with your financial goals.

Here's a recap of the 10 reasons to sell a losing position and ways to assess when you need to do so:

The Bottom Line

Selling a losing position is more art than science. It requires a balance between objective analysis and strategic decision-making. Recognizing when to cut losses and considering factors such as opportunity cost, liquidity, transaction costs, and psychological biases enables you to work to protect your capital and reallocate it to more promising prospects.

Mastering this skill minimizes potential losses and enhances long-term portfolio performance by ensuring that investments align consistently with your goals and market conditions.