What questions to answer to help decide whether you should sell, hold or buy more of an underperforming investment.
In this episode you’ll learn:
- Why we use rules of thumb or heuristics.
- What is the disposition effect.
- What questions should you answer when you have an investment losing money.
- What are master limited partnerships (MLPs) and what are their investment characteristics.
Dispositions Effect: A Review of Literature – Neeraj Amarnani
Mental Accounting Matters – Richard H. Thaler
What To Do When An Investment Loses Money
Despite our best efforts to thoughtfully select investments that only go up in value, there are times when investments fall in price and we lose money.
Perhaps those losses are only on paper because we haven’t sold the underperforming investment.
I find paper losses feel just as bad as realized losses. In fact, in some ways paper losses feel worse due to fear and angst that the investment could fall further, worsening the loss.
Realized losses are painful but at least the pain and regret gradually fade with time.
The Disposition Effect
Yet, numerous academic studies show investors are more likely to hold onto their losing investments and sell their winners. This is called the disposition effect.
A more rational approach from a capital gains tax perspective would be to sell the losers and hold onto the winners.
Investors are not rational. We would rather sell a winner because locking in a profit gives us a psychological boost and reinforces our self-perception as successful investors.
At the same time, we are willing to endure the pain of a losing investment because there is always the hope the investment will rebound and selling a loser means facing the regret of having made a mistake.
A mistake suggests one should have known better. That there was a different path that should have been taken.
Perhaps it could be considered a mistake if one loses money on an individual stock, but if the underperforming investment is a low cost index fund or exchange traded fund that replicates an entire asset class is that really a mistake?
Master Limited Partnerships
I have about 10% of my liquid portfolio in a severely underperforming asset class called master limited partnerships (or MLPs). These are investments in energy infrastructure such as pipelines and storage facilities.
The investment has fallen over 20% in the past year. I am losing money. And it feels awful. To make matters worse, with my encouragement, my parents hold the same investment.
Here are a few questions I ask myself when I have a losing investment in order to decide whether to keep it, sell it or buy more.
Why did I buy the investment and has the thesis changed?
When I purchase an investment it is usually because it has a return driver that differs from other holdings in my portfolio, and in most cases because investment conditions are attractive.
In the case of MLPs, they generate an income yield of over 6% and the income MLPs generate to pay those dividends comes from transporting and storing oil and natural gas.
MLPs are like a tollbooth on a highway in that they collect fees from oil companies to move and store oil and natural gas. They collect those fees irrespective of energy prices.
In addition, MLPs have grown their distributions at 6% per year over the past five years as the U.S. goes through a major expansion of its energy infrastructure.
Theoretically, MLPs’ annualized return equals their dividend yield plus the distribution growth rate. At current yields and distribution growth rates that equates to a return of over 12% per year.
That is close to the 11.5% annualized return the Alerian MLP Index returned for the five and ten year periods ending June 30, 2015.
Unfortunately, MLPs are also volatile so while the asset class did return 11.4% annualized over the past decade it was not a smooth ride.
In 2008, the Alerian MLP Index declined 37% while in 2009 it gained 76%. There were other years when the index gained between 4% and 40%, but for the year ending July 24, 2015 MLPs declined 25%.
Why are MLPs so volatile? Because they are a relatively new asset class that are misunderstood by many investors, and as I mentioned earlier, investors are irrational. They go through periods of panic and fear followed by periods of exuberance.
That means investors are constantly reappraising the value of MLPs. Even though yields and distribution growth have been relatively steady the value investors place on that income stream and its growth varies dramatically over time.
Despite this volatility, the underlying thesis for why I purchased MLPs hasn’t changed.
Even with the drop in oil prices, the U.S. is going to continue to build out its energy infrastructure. Global demand for oil and natural gas in the decades ahead will continue to increase while supply growth is constrained by the difficulty of finding new sources of oil.
Impact of Additional Losses
What happens if this asset class falls further? Will it undermine my lifestyle?
No. At 10% of my portfolio it is not too large of a position that it would impact my day-to-day ability to cover my living expenses.
Which mental account is this investment classified?
Investors classify investments in different mental accounts based on expected holding periods, potential use of funds, expected volatility etc.
MLPs for me are a long-term holding that are expected to be highly volatile while paying a high dividend yield. Even though the current downtrend is uncomfortable, the investment is acting in a way consistent with the mental account I have for it.
Am I suffering from the disposition effect? Am I afraid to sell the investment because I will experience regret for making a poor investment choice?
Perhaps, but I don’t think so. MLPs are yielding more than their historical average relative to bonds and other yield oriented investments like real estate investment trusts.
In short, they are more attractive today than they were a year ago while the investment thesis and return drivers haven’t changed. I should be buying more. In fact, earlier this month I did.
Still, I really, really hate to lose money investing so I will hold on and suffer through.