Investor's Business Daily, July 16th, 2007
Keeping losses small is an absolute must in investing.
In his 1935 book, "The Battle for Investment Survival," legendary stock investor Gerald Loeb called curtailing losses "the most important single investment device."
Loeb added that "it is also the action that most people know the least about and that they are least liable to execute."
It's hard, after you've identified what you're convinced will be a winner, to admit that you chose a dud.
While a stubborn refusal to accept defeat can be a virtue in many of life's pursuits, it's just a recipe for bigger losses in the stock market.
Even worse than letting your losses run past 7% to 8% is piling more money into a losing stock. By hoping and averaging down, you're creating a potentially bigger loss. To illustrate how tough it is for a plunging stock to turn around, just imagine trying to catch a falling knife.
As the accompanying chart shows, an 8% loss requires only an 8.7% gain on the next trade to get back to even. But let that loss run to 15%, 25%, 50% or more, and it gets tougher to dig out of the hole.
At that point, emotion can take over. The investor tries to make up for the loss with a long-odds investment that can lead to even more losses. But the investor who has the humility to recognize a mistake and cut losses quickly preserves capital and emotional balance.
After that 8% loss, it's important to "go to the videotape." You don't want to move on to your next trade until you find out what went wrong.
Did you ignore certain flaws in the fundamentals or chart? Was the overall market sending cautionary signals that you shrugged off? Was the stock in a strong industry group within a strong sector, or did you buy a weak sister instead?
IBD database studies show that most leading stocks breaking out of sound bases do not fall 8% from the buy point. That's another reason to get out while the loss is still small.
