Cut your losses short!
To new or experienced investors, you are not going to be right all the time. What matters most is what you do when you are wrong (your stock drops below your purchase price). Sooner or later a small loss will turn into a financially crippling loss. Your stock and the market does not care about your ego, pride, education or how smart you are. If you are going to invest in individual stocks you MUST have a loss cutting rule.
To make matters worse, sooner or later a stock you sell will turn right around and go back up (The Dreaded Shake Out). Amateur investors conclude that they shouldn’t have sold, they say "see, Chad doesn’t know what he’s talking about". So what do they do the next time they buy a stock and it drops? Not this time, I’m not getting tricked out of this one. Guess what, sooner or later the stock you didn’t sell for a small loss is now a stock you might own forever and at drastically lower prices. Emotions have no place in the investing world. Learn to become mechanical when it comes time to take a loss. It’s a rule, it’s there to protect you. Sell at market and move on. When you have established rules, it will take the emotions out of investing.
The number one reason so many people lost money during the Internet Bubble and the 2007-2008 Bear market is because they didn’t know how to play “Defense”. It’s really easy to buy a stock but I have rarely met a person that knows how to sell. This includes selling on the way up to lock in profits and rarer yet, sell when they are wrong to take a small loss. Most people and this included the so-called professionals, continue to promote stocks even after they have topped and the market is in a correction.
Back in 2000 when the Market had already begun to top and turn lower, a parade of “experts” and analysts continued to preach day in and day out on Business TV “Buy the dips”, some were even raising Yahoo and AOL Price targets to ridiculous levels, even as the stocks themselves were cratering. These so-called experts preaching to buy the dips and buy on the way down caused even more damage to investors.
I can always make it back on the next one:
If the stock you own falls from $50 to $25 (50%) do you realize you need to find a stock that doubles just to get back to break even? What if the stock you own only drops 37%? You still need to find a stock that increases by 60%. Think about the folks that on average lost 75% during these tough Bear markets, they had to invest in stocks that increased 300% just to get their money back. DO you know how hard it is to find a stock that increases that much??? They are rare. It can be done, I’ve done it and the very prepared investor has done it and continue to do it but they do not come along every day.
In a few moments, I’ll give you a few pieces of advice that can change your investing results for the rest of your life if you have the discipline to actually follow them.
Historical fact: Usually only 1 out of 8 leading stocks in the prior Bull Market will establish itself as a leader in the next Bull Market. The economy changes and the competitive landscape changes, meaning the markets typically looks to new industries and sectors for future leadership.
Advice number 1: Learn to sell while your stock is still advancing. Learn to read and interpret Price/Volume action. With time and study, you will become better at letting your winners ride and maximize your profits. You will never sell at the exact top, however, with time and study you will begin to ride your stocks as long as possible to maximize your gains.
Advice number 2: Learn to cut your losses short. Have a plan to sell BEFORE you ever make your purchase. I have a 7% stop rule. If the stock I purchase doesn’t act right, take off on huge volume and languishes near my buy point for a few days, I’m gone. If the stock I buy immediately goes down by 7% from my initial buy point, I’m gone.
Based on historical studies of the Greatest Stocks and proper chart patterns, 7% is the ideal sell trigger. Growth stocks from history, breaking out of proper bases should immediately show you a profit and if they do not, something is wrong. It could be the overall market, supply and demand within the stock itself or a 100 other factors not known yet. However, whatever the reason, the stock is going down, GET OUT.
Pro Tip: Never add more money to a position that is showing you a loss. Remember, this applies to individual stocks, not your long-term ETF or Mutual Funds. Dollar Cost Averaging in an ETF or Fund is a wise long-term strategy.
I will talk about how to find proper buy points in the future but remember this; if I’m only correct on 3 out of my 10 stock purchases and I keep my losses small, I will show a net profit. The stocks we look for and buy at the right moment typically advance 25%+.
The Dreaded Shake out
Nothing is more frustrating. I have been there more times than I care to remember. It's part of Growth Investing. In time we all get better at holding tight and not getting scared out of our stock (provided it doesn’t trigger our 7% loss-cutting rule). Cutting our losses short provides insurance against our stock getting hammered and sinking to unimaginable levels. If you keep your losses small, you are still in the game. It takes time to learn how to invest in these Super Stocks. If you let your losses get away from you, you’ll never have a chance to make serious money that can materially change your life.
But Chad, I own Blue Chips
So-called “Blue Chips” are still stocks and as they say “When they raid the house, they get everybody”. I remember meeting new potential clients after the internet Bubble and especially after the housing crisis. They would tell me things like “I’m a long-term investor”, “Stocks always come back”. Yes, stocks in general always recover but not all individual stocks come back. Even if you are lucky and the stock you own recovers, how much money have you left on the table waiting years or decades for your stock to get back to even?
Look at these “Blue Chips” and how they fared during Bear Market of 2000-2002:
AOL lost 91% of its value
AT&T lost 83%
Amazon lost 95%
Apple lost 86%
Circuit City Bankrupt
Corning (A freaking Glass company) lost 99%
Goodyear lost 96%
The list goes on and on and on.
Lock in profits and find the next leader when the Bear comes out of hibernation.
The Great Jesse Livermore once said “people hope when they should fear and fear when they should hope” What he meant is that investors usually hope that their stock will come back when it falls in price and they fear they will lose their profit when they have one. What smart investor “feel” is the opposite. Smart investors Fear their loss will get bigger and hope their profits will continue to build as the stock goes higher. If you can “feel” the latter instead of the former, you’re one step closer to becoming a smarter investor.
Selling your stock for a loss is the hardest part of investing. It’s not personal, the stock you own is not your child, your friend or a pet, it is a business decision. Some will never learn this until it’s too late. The ones that do learn it, are at the doorstep of building a secure financial future.
Until next time, Be the smartest Investor in the room.
Welcome to the Nerdery,