Will You Capitulate?

By SmartProInvesting.com Stock Investing Team.
May 5, 2008

One of the striking things about the stock market is the hype that’s often associated with it. Most commentators tend to just focus on the money-making potentials of the stock market. Often, the huge gains made on stocks (which are often true) are what get loudly highlighted. Not much is said about the stock market losses that are not only possible but do also occur. Bullish has always been sweater music to the ears than bearish.

It shouldn’t be a huge surprise that the emphasis is on the profit-making dimension of the market. One, it’s only natural to tend to accentuate the positive and downplay the negative. Secondly, the stock market, on the average, would be said to offer more of money-making than money-losing opportunities. Over time, people have come out better off than worse off. Part of the reason is that there are longer stretches of bullish periods than the bearish intervals. For people who invest long, the odds are in favour of coming out significantly richer. Yet, substantial losses do occur, because it's part of the market cycle to have bear periods of brief or extended decline of prices.

Take the last two months or so on the Nigerian stock exchange. The bears took over the market and in that period, market capitalization has dived by a whopping N1.16 trillion. What that says, too, is that a lot of investors have lost money. That’s the sad part of the market. Watching your portfolio shrink day after day, week after week is nobody’s idea of fun. It could be a traumatizing experience. Different investors react eventually in different ways to the continued slide in the value of their investment. Capitulation, unfortunately, is one such possible response and one that could be quite harmful to the investor’s interest.

Capitulation occurs when investors finally lose faith and dump their shares. It reflects the frustrations an investor could experience over his dwindling fortune in the face of falling market prices. It’s the final buckling over to the tasking prospect of watching the value of one’s portfolio shrink even further. It gets to a point where the investors succumbs to that frustration and says “to hell with it!”, crashing out of the market by selling off at whatever value that can be realized. He possibly swears not to have anything to do with the stock market again, which is understandable, given the huge loss that has been picked up. Capitulation could be fairly widespread, with many investors dumping their stocks just to salvage what is possible as the market looks to continue its descent.

Think about it though: is it good investment judgment to capitulate at the late hour? Selling off one’s stock early in the decline would make sense. If you sale relatively early and move into near-cash assets (bank deposits, treasury bills, etc) or other securities, you can return when the market finally reverses its decline. That will certainly mean a lot of profit: you took much of your earlier earnings and you now position for more by buying at the base. The problem, however, is that it’s never easy to time it that expertly. It’s difficult to determine if a decline will persist into a full bear market or at what point it has finally bottomed out.

That's why you find people holding their stocks as the prices head down. What starts as a minor price correction eventually persists and before they realize it, prices would have declined substantially, making it unattractive to sell off. Unfortunately, it’s difficult to predict the end, meaning that it could continue to drop. However, to finally throw in the towel and dump your shares at rock-bottom prices is not just costly but ill-advised and here’s why:

  • Let’s face it, its market action that changed, not the state of your investment. The companies you bought into are alive and still in their normal course of business, notwithstanding that the market has pounded their prices. Unless you have immediate need to sell your shares or use their market value to, say, support a borrowing, these current prices haven’t really destroyed your investments. If the companies were really worth their previous prices, they will return to those levels the moment the market ‘madness’ is over. In effect, for as long as you mean to hold your investment for some time, the temporary change in their prices hasn’t done any permanent damage.
  • If you sell low and incur transaction costs and have to re-enter at prices not far different, the loss in transaction costs is likely to compound your misfortune. It’s enough that your investment lost value. To now hand significant sums to a broker for selling and buying back, in addition, stretches your loss.
  • If you fail to buy back at the right time, you may find that you re-enter the market at higher than the prices you sold. When prices reverse and begin to head up, you are likely to have some difficulty buying back as no reasonable investor will want to sell at that point. Prices will need to rise to a level (perhaps far above where you sold) to attract selling. In effect, you lose more money for the emotional response of dumping your stocks at the wrong time.
  • If you fail to re-enter at all, thereby throwing away any opportunity at all of recouping your earlier loss, you become a total loser – not an attractive prospect.

That is why capitulating at the late hour will hurt your interest. Granted that it's looks hard to swallow that your investment value has gone down, thinking more positively now is more helpful. Ironically, that includes looking out for stocks you can buy now at the seemingly low prices.


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