Successful investing isn’t all plain sailing, and now and again you must take the rough with the smooth.

It would be lovely to think you could put your savings in lots of guaranteed winners and never have to worry about looking at your portfolio again until you need to the money, but sadly markets don’t work like that.

Even the least volatile, most boring investments will occasionally go through periods of underperformance – what matters is how you respond to that underperformance.

THE FIRST RULE: DON’T PANIC

It may sound trite but, if you are sitting on losses, the last thing you should do is panic and sell everything ‘in case it goes down even more’.

Markets move in waves, rather than cycles, with upward bull phases and downward bear phases, but over the long term they tend to go up as companies generate higher earnings and valuations rise as a result.

There is also the effect of survivor bias, where loss-making or poorly-run companies gradually disappear to be replaced by more profitable, more successful ones.

Assuming you are a buy and hold investor rather than a short-term trader, and you plan on owning your stocks a long way into the future, the day-to-day ups and downs of the market are not that important.

I bought the shares in 2021 but it’s fallen ever since. What do I do?

In The Intelligent Investor, Benjamin Graham offers the following analogy: ‘Imagine that in some private business you own a small share that cost you $1,000. One of your partners, named Mr. Market, is very obliging indeed. Every day he tells you what he thinks your interest is worth and furthermore offers either to buy you out or to sell you an additional interest on that basis.

‘Sometimes his idea of value appears plausible and justified by business developments and prospects as you know them. Often, on the other hand, Mr. Market lets his enthusiasm, or his fears run away with him, and the value he proposes seems to you little short of silly.

‘You may be happy to sell out to him when he quotes you a ridiculously high price, and equally happy to buy from him when his price is low. But the rest of the time you will be wiser to form your own ideas of the value of your holdings, based on full reports from the company about its operations and financial position.’

WHAT ABOUT THE ‘EFFICIENT MARKET’?

The fact is, there is no such thing as an ‘efficient market’, where all the news and information that could possibly be known about a company is reflected in its share price.

For starters, most investors have a different approach to one another when it comes to choosing stocks and indeed about what constitutes a good or a bad company.

Even highly-paid investment bank analysts – who are employed to forecast how well or how badly a company is likely to do and therefore what its intrinsic value is – often have completely conflicting views on the same stock.

Zoom is a classic example of investors racing to buy the shares and then earnings growth failing to match expectations

Also, depending on what is in vogue in the market at any one time – such as technology stocks, oil companies, banks – expectations for these businesses can reach unrealistic levels and the shares, which will also have been driven to unsustainable levels, can come crashing down.

Providing you aren’t caught up in the hype and invest everything at the top of the market, you are likely to make money over the long run – in fact, studies have shown that even if you do invest at the top of the market, you still make money long-term, it just takes longer.

WHAT DO I DO ABOUT LOSSES?

There will undoubtedly be times when a company you are invested in disappoints and the shares sell off.

This is the time to revisit the investment case to see whether it still stacks up – for example, is the company doing what you thought it would, is it growing as fast as you expected, is the dividend as big as you were led to believe, and so on.

If you still believe the long-term argument for owning the shares, the trick is to have the courage of your convictions and add more, but if you feel the company no longer measures up to expectations then you should sell and move on, with no regrets.

The key is not to get caught like a rabbit in the headlights and do nothing, which is how many investors react because they fear taking losses. This phenomenon is known by psychologists as ‘loss aversion’, the fear of losing money, which is a much stronger emotion than the pleasure we get from making a profit.

There have been plenty of periods when shares in Games Workshop have fallen, but the investment case hasn’t changed and the shares have bounced back on plenty of occasions 

As Warren Buffett, chairman of US investment company Berkshire Hathaway (BRK.B:NYSE) and one of the world’s best-known investors, succinctly put it: ‘You don’t have to make it back the way you lost it.’

The best investors always learn from their mistakes – and great investors still make mistakes, they aren’t superhuman.

In his book, Simple, But Not Easy, former Mercury fund manager Richard Oldfield devotes an entire chapter to what he calls his ‘howlers’ and the lessons he learned from them. It’s well worth a read.

HOW CAN YOU REDUCE LOSSES?

One way to reduce the likelihood of losses is to reduce your tolerance for risk, so it’s important you are honest with yourself about what you are hoping to achieve as an investor.

If you are happy to settle for an annual average return of 5%, with a modicum of risk, you can invest everything in a global tracker fund. Just don’t check its performance every five minutes because the more frequently you check the greater the likelihood you will be running a small loss.

If you want higher returns and are prepared to accept a higher degree of risk, you can still try to build a portfolio which is resistant to major market selloffs, because, as the statistician and author Nassim Taleb said, not seeing a tsunami or economic event coming is excusable but building something fragile to them is not.

Try to avoid putting all your eggs in one basket – whether that is not holding lots of stocks, funds or investment trusts which are related to the same sector – and maybe think about equal-weighting your investments so that if one stock blows up it doesn’t damage your entire portfolio.

SHOULD YOU EVEN WORRY ABOUT LOSSES?

As we said to begin with, if you are a buy and hold investor then you shouldn’t be bothered with the day-to-day gyrations of the market.

This is even more relevant if you have income-generating investments because you want to leave your capital where it is and keep compounding your dividends for as long as possible by
reinvesting them.

In fact, you might even welcome a period of share price weakness as it means with your dividends you can buy more shares than you would be able to if the price was higher.

Every study of stock market returns comes to the same conclusion – most long-term gains don’t come from capital appreciation, they come from reinvested dividends, so maybe instead of shooting for the stars and taking lots of risk the way to avoid big losses and still win in the long run is to let compounding do the job for you.

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