Be ruthless in cutting your losses

Q: I've read where you suggest selling stocks if they fall 10% from the price you paid. Is that true even if the stock pays a 10% dividend yield?

A: I don't want anyone to be confused: Investing in stocks is a risky proposition. If it wasn't risky, you wouldn't get any return.

But just because investing is risky doesn't mean you have to lose it all.

There are several ways investors can reduce their risk without harming their returns.

The first way is diversification. If you buy a basket of stocks, rather than just one, you can spread your risk over dozens of companies in different industries and financial situations. Diversification essentially eliminates your exposure to "company risk."

But what if you don't want to diversify? Maybe you think you've found a hot stock that everyone else is missing. And to be sure, sometimes investors can be smart enough or lucky enough to pick a stock that outperforms other stocks in its class. But here, you have a problem of risk.

If you buy the stock and tell yourself you're going to hang onto it no matter what happens, you're exposing yourself to huge risks and likely not being compensated for taking that risk. A logical way to avoid that kind of risk is to cut your losses.

Can a stock go down 10% from your purchase price and rally again? Certainly. But think of the cut-off rule as insurance. You are paying for the right to reduce your risk to just 10%. Keeping losses on individual stocks to 10% is important because it's possible for you to recover from a loss of that size.

But you're right, the 10% rule doesn't apply to all investments. I suppose if a stock pays a 10% dividend you could use that as somewhat of a buffer and give the stock a little more room. But I wouldn't put too much faith in the dividend. What good is a 10% dividend if the stock goes down 20%?

Also, the dividend yield may be misleading on a plummeting stock. As the stock falls, the dividend yield rises, because it is calculated by dividing the dividend by the stock price. One strategy might be to add the actual amount of dividends received on the stock to the cost basis. You can then use that adjusted cost basis as your baseline to apply the 10% rule.

Again, the 10% rule doesn't apply to an investment in a diversified portfolio of stocks. In that case, you would be foolish to sell if the basket fell 10%. Why? Because you have already reduced your risk with diversification. Sticking to diversified mutual funds may be a good strategy for investors who think the 10% rule on an individual stock is too strict.

If you'd like to learn more about the 10% rule, read The Battle for Investment Survival by investor, broker and writer Gerald Loeb. The classic, written in 1935, teaches investors why cutting losses is so important.

Matt Krantz is a financial markets reporter at USA TODAY. He answers a different reader question every weekday in his Ask Matt column at money.usatoday.com. To submit a question, e-mail Matt at mkrantz@usatoday.com.

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