The Right Reasons to Dump Your Losers

Making a losing investment is always frustrating. On top of the obvious negative of seeing your hard-earned money go up in smoke, owning a loser also forces you to make a tough decision: Should you dump what you thought was a promising investment, or should you hang on in hopes of a rebound at the risk of losing even more money?

Depending on your investing temperament, you may well find yourself feeling pulled one way or the other based on emotion alone. But in order to evaluate the situation objectively, you need to stay rational and try to assess the future prospects of your investment without letting emotion come into play. Here are three helpful guidelines to follow in making the right decision.

1. Dump a loser if it doesn't behave the way you expect.
Often, you'll make an investment in the belief that a favorable trend or beneficial news will push its price up. So if the event you hoped for actually happens but your investment doesn't react the way you thought it would, then you need to reassess your reason for owning that investment. If you aren't satisfied by any explanation for the loss, don't hesitate -- dump your loser.

For instance, many investors buy shares of the United States Natural Gas ETF (ASE: UNG) because it's designed to track the movements of natural gas prices. With the price of natural gas having plunged over the past several years, value-hunting investors seeking a bottom in the natural gas market are drawn to the ETF as a rare direct way to play a rebound.

But when you look at the way that the ETF has reacted, you'll notice that over longer periods of time, the ETF has badly underperformed the spot price in natural gas. The technical reason has to do with the futures contracts that the fund uses, which leaves the fund having to pay higher prices when it rolls over expiring contracts to buy new ones. If you expected the ETF to track gas prices better over periods of months or longer, then it only makes sense to dump it once you see that it doesn't succeed in doing so over the long haul.

2. Dump a loser if its competitors keep crushing it.
In some industries, certain companies seem always to produce worse returns than their peers. Often, value investors jump into the relatively underpriced stock in the hope that its woes are cyclical and that it will eventually catch up.

Keep in mind, though, that just because companies are in the same industry doesn't mean that they operate the same way. For instance, if you've been to Las Vegas, Caesars Entertainment (NAS: CZR) may seem to be in the same class as Las Vegas Sands (NYS: LVS) , Wynn Resorts (NAS: WYNN) , and other major casino companies. But Caesars has far more exposure to the relatively weak domestic gaming market outside Las Vegas, while Wynn and Sands have lucrative locations in Macau that have helped sustain their profits for years. With Caesars having missed such an essential moneymaking opportunity, dumping it is perfectly justified if you thought it had the same potential as its more globally diversified competitors.

3. Hang on to a loser if the jury's still out on its thesis.
It doesn't always make sense to dump a loser. In particular, if a company or fund has a plan for success that hasn't had time to play out yet, consider giving even a losing investment a second chance.

An example of this case is the Fairholme Fund. During 2011, the fund, run by award-winning manager Bruce Berkowitz, produced huge losses with its concentrated bets on AIG (NYS: AIG) and other big financial stocks. When bank and insurance stocks didn't recover as quickly as investors had hoped, they got stuck with big losses, and many fled the fund. Yet so far this year, the fund has recovered much of last year's losses, thanks to big rebounds in the financial companies that Berkowitz bought. The fund was undoubtedly early, and it hasn't earned back all of its losses. But if you sold at its lows, you missed out on the rebound.

It isn't easy
These rules sound simple, but they're really hard to apply when you have an actual losing investment. Just by using a framework like this, though, you can avoid making impulsive decisions that lock in losses permanently.

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Fool contributor Dan Caplinger has no positions in the stocks mentioned above. You can follow him on Twitter @DanCaplinger. The Motley Fool owns shares of and has options positions on AIG. Motley Fool newsletter services recommend AIG. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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