Ideally, the stocks you purchase after careful research and analysis will have long and profitable lives in your portfolio, growing contentedly through shifting economic conditions, trends in the market, and phases of your life.
But sometimes, despite our best efforts, we get it wrong. And what we do after we realize that we've misappraised a stock can have a major impact on our financial health.
Amidst Biogen's (BIIB 3.50%) ongoing fiasco with its Alzheimer's drug Aduhelm, I ended up selling my shares because I believed that my investment thesis had been disproven. But selling a stake isn't the only path to take -- and being prepared for the day when you get a stock wrong will go a long way toward limiting the negative impact. So let's investigate in more detail, using my recent experience with Biogen as an example.
Image source: Getty Images.
How to tell when you got it wrong
If your investment thesis is as simple as "I think this stock will outperform the market because its product is superior and therefore bound to be selling faster than the competition," you'll know what evidence to the contrary might look like. A couple of quarters of weak revenue growth compared to competitors should make you start to question your initial judgments.
My investment thesis for Biogen was roughly that the company's drug Aduhelm would bring in massive new revenue growth for years to come: The drug would be entering an untouched market, assuming that it got approved. Because I invested in the stock in the middle of last year, I knew that I was exposed to the risk that Aduhelm wouldn't meet the U.S. Food and Drug Administration's standards.
As it turned out, Aduhelm was approved by the FDA earlier this year, sending Biogen's stock surging. Shortly afterward, problems with Aduhelm began to pile up, and they started to chip away at my thesis. The potential market for the drug shrank immensely as a result of its sky-high price tag and questionable efficacy. Now, some physicians and medical systems have committed to not administering Aduhelm.
Needless to say, I didn't anticipate these problems or their potential to curb future revenue when I was working on a list of reasons to invest in Biogen. Eventually, I had seen enough, and I sold my shares.
How much data needs to pile up before you admit there's a problem is up to you. But be aware that a stock's daily, weekly, and monthly price movements are not high-value pieces of information on their own. Your thesis can still be valid when a stock is underperforming for a time, and the reverse is also true.
Think about the options
There are a few things you can do when you realize that your reasons for investing in a stock are looking incorrect, obsolete, or incomplete.
The simplest action is to do nothing, which was the first thing I did when I started to lose faith in Biogen. Doing nothing is (effectively) choosing to disregard your new judgments about a stock in favor of your older judgments, even though they're becoming less plausible. While it might seem overly passive, the advantage of not acting immediately when your investment thesis is disproven is that your views get more time to evolve.
After all, our perceptions about the merit of our own theses are not always accurate, nor are our perceptions of business and market environments. What might seem like an insurmountable obstacle for a company today could easily be in the rearview mirror tomorrow. Still, lingering on a stock you don't believe in for too long isn't a good idea.
You could also decide to sell your holdings in full, as I did with Biogen. Sometimes, when you've lost confidence in a company, getting out is the right choice, even if it means taking a loss. Waiting for things to improve can be a losing proposition, especially if the business factors or competitive environment have shifted significantly in a way that you can articulate.
And finally, if your investment thesis has been comprehensively disproven and you anticipate things will take a turn for the worse -- and you're ahead of where you started -- there's little reason to hesitate before selling all of your shares.
Image source: Getty Images.
A more nuanced approach is to sell a portion of your shares to reduce the stock's weight in your portfolio. Paring your holdings will give you back some cash, and it'll also stop your portfolio's overall value from being dragged down as much by future underperformance of the stock. Of course, you'll still have shares on hand afterward, so this tactic is probably best for situations in which a few elements of your investment thesis are still holding up.
Likewise, if your shares are now worth more than you purchased them for, selling some of them will lock in the gains, which is especially handy when you're not fully confident that your thesis is actually wrong. While I could have chosen this path with my Biogen shares, I preferred not to stay exposed to the stock's declining value.
Then there's what I'll call the contrarian approach, in which you buy more shares when you realize that your thesis doesn't fit reality. I don't recommend this, unless your revelation is that there's a different and much more compelling thesis in favor of buying the stock which supersedes your initial take.
Understand and adapt
One of the best tricks I know in investing is to write down your investment thesis before buying a stock. Making your reasons for investing explicit tends to expose both wishful thinking and gaps in your understanding of a company or an industry. Then, if your thesis is later disproven, write another note about how you were wrong, and why, before deciding what to do about it.
Frustrating as it may be, try not to be too hard on yourself when you get a stock wrong. As long as you're building experience and using a system to avoid making the same mistake twice, it'll be hard to go wrong consistently in the long run.
