Coming to grips with the fact that you’ve made a bad investment can be a difficult and painful process.
After all, the reason you bought the investment in the first place was that you expected it to make you money. So when stocks or funds move the other direction, it can be a bitter pill.
But even the most talented investors on Wall Street make bad investments. In fact, you’re in good company if you’ve made an investing mistake. Honestly, there’s no need to beat yourself up or panic.
But you will need to evaluate the investment honestly. And, in some cases, you may need to take action to minimize the damage. Here are five steps to take to recover from a bad investment.
1. Make Sure That You’ve Set Realistic Performance Expectations
Before you move into “recovery mode,” take a step back and consider whether your investment was so terrible after all. And, to do that, clearly define what a “bad” investment means for you.
You might read an investment blogger who says that he never makes less than 30% per year or follow a celebrity trader who supposedly earns 10% every month. But for the average investor who can’t spend all day researching stocks and making trades, these kinds of numbers aren’t realistic.
One benchmark (among others) that can help you objectively evaluate your investment is the S&P 500. If these 500 stocks averaged an overall return of 10% during a certain period and your investment made 5%, then, yes, your investment underperformed. However, you still made money. So I would hesitate to label this a “bad” investment. There’s a difference between “less good” and “bad.”
However, if one of your investments lost 10% during this same period, we’re definitely moving into the “bad” investment territory. The further and the longer that your investment lags behind the entire market, the more you’ll want to seriously consider taking action.
2. Avoid Panic Selling OR Buying
So you log on to your brokerage account one morning and find that stock you own dropped 15% overnight due to a disappointing earnings report. What should you do? Sell all your shares? Buy more?
In many cases, the best answer may be to wait. Why? Because panic selling and buying are both risky moves. Let’s take a closer look.
The Danger of Panic Selling
In our first point, we said that if an investment underperforms when compared to the market as a whole, it may be time to take corrective action. But it’s important to consider your timetable. Are we talking about a period of a few weeks, months, or years?
The shorter the period, the higher the chance that a recent drop in stock price is not indicative of a long-term trend and that it may reverse course on its own.
For example, if you owned shares of Apple at the end of 2018, you suffered a major short-term decline in value. Apple’s stock price fell from $225 on September 28th, 2018 to $148 by January 4th, 2019. That’s a 34% drop in a matter of three months!
Apple shareholders who panicked sold their stocks. Turns out, they sold at the very bottom and thus “locked in” losses of 34%. That’s pretty devastating. But those who took a deep breath and stuck things out saw the stock make a near full recovery by May 2019. And, despite a few more similar bumps along the way, Apple is now trading (at the time of writing) at over $380.
This example demonstrates why a long-term, buy-and-hold perspective can help investors avoid selling too quickly based on short-term market volatility.
The Danger of Panic Buying
The second ill-advised strategy that investors can adopt when an investment quickly declines is to buy more shares. The thought process is that by buying more shares at the lower price, your average share price for the stock also goes down.
For example, if you bought 50 shares of a stock at a $100 price point and later purchased 50 more shares at $50, your average share price decreases to $75. Put another way, the stock needs only to rise above $75 for the position to become profitable. This strategy is often referred to as “averaging down.”
Averaging down can be a viable strategy worth considering, but only for buy-and-hold investors with long-term investment horizons. If you own shares of an index fund or blue-chip stock that you know you won’t be selling for 15 years or more, then averaging down could work.
But averaging down with more speculative investments (like startup stocks) can be dangerous. There’s no guarantee that a stock that dropped 25% last month won’t drop another 25% this month and the month after that. By panic buying in an effort to “fix” your bad investment, you could just be throwing good money after bad.
For these reasons, making knee-jerk decisions in either direction (buying or selling) can really hurt you as an investor. Waiting for long-term trends to establish themselves before getting out (or going in more) is generally a wise first impulse.
3. Understand the Benefits of Tax-Loss Harvesting
Tax-loss harvesting is a strategy that makes it possible for your bad investments to do you some good. The basic idea behind tax-loss harvesting is that you sell an investment that has declined in value to realize its capital losses and offset the capital gains of other investments.
Even investors with long-term investing strategies can take advantage of tax-loss harvesting. To do so, you simply replace the investment you sold with a reasonably similar investment.
For example, let’s say that the energy sector has been hit hard and an energy stock you own is down $2,000 for the year. By selling the stock and replacing it with a similar energy stock, you get to enjoy the tax advantages of the $2,000 realized capital loss today while still positioning yourself to make future profits if the energy sector rebounds.
But what if you don’t have any capital gains to offset? In that case, the IRS will allow you to use up $3,000 of capital losses to offset ordinary income. And the rest can be carried forward indefinitely, ready and waiting to be used towards offsetting future capital gains.
Tax-loss harvesting isn’t allowed by the IRS if you buy and sell the exact same investment or a “substantially identical” investment within a 30-day period. To avoid running up against this “wash sale” rule, consider replacing individual stocks with mutual funds or ETFs in the same industries.
If this all sounds a little complicated, the good news is that you don’t have to do all of this yourself. For many investment advisors and robo advisors, tax-loss harvesting is a core part of the standard services they offer.
4. Prioritize Diversification Moving Forward
Remember the Apple investment example that I gave earlier. Well, for me, that wasn’t just a hypothetical story. I did own shares of Apple stock during that time period from September 2018 to January 2019.
At the time, the big short-term decline was definitely distressing. In retrospect, however, I’m so thankful that I avoided the urge to panic sell.
One of the reasons why I was ok with letting my Apple investment “play out” was that it only represented a small percentage of my overall portfolio. Diversification is such an important part of investing because it minimizes the negative impact that one bad investment can have on you.
Many experts say that you should never have more than 5% of your portfolio invested in one security. One great way to diversify your portfolio is to buy mutual funds or ETFs. By buying these baskets of securities, your $100, $500, or $1,000 could literally make you an owner of tiny pieces of hundreds or thousands of companies.
Fractional share investing is another way to keep small position sizes while still having the opportunity to invest in individual stocks. With fractional share investing, $100 could buy you a little piece of Amazon, for example, despite the fact that full shares are currently trading above $3,000.
5. Seek Help from a Financial Advisor or Robo-Advisor
If you’d like expert advice on how to handle a bad investment, you might want to seek out the assistance of a Certified Financial Planner (CFP) like Paladin. They can help you develop a comprehensive financial plan and build a diversified investment strategy that matches your goals.
Another option to consider is using a robo advisor platform. Robo advisors build custom portfolios with an asset allocation profile that’s based on your specific risk tolerance level. Most robo advisors also offer automatic rebalancing so that your mix of stocks to bonds is always in line with your target asset allocation.
One of the biggest benefits of robo advisors is that their cost is usually much lower than the typical CFP advisory fee. For example, Betterment and Wealthfront’s advisory fees both start at 0.25%. And M1 Finance doesn’t charge any advisory fees whatsoever. If you’d really like to talk to a human advisor, most robo advisors offer access to them for an additional fee. See our top robo advisor picks.
Stock market investing can be a confusing and maddening enterprise. Stocks that seem like “sure things” can disappoint while others that seemed destined to drop climb high.
The short-term unpredictability of the stock market is another reason why taking a long-term approach to investing is such a smart idea. And always remember — the more you diversify your portfolio, the less damage one bad investment can cause.