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Know When To Fold 'Em
Nobody's right all the time in the market, not even veteran market professionals. But as the famous investor Bernard Baruch once said, "Even being right three or four times out of 10 should yield a person a fortune if they have the sense to cut losses quickly."
Being a successful investor is just as much about limiting losses as it is about riding a winning stock. Downturns are a part of life in the market, and you must act decisively to shield yourself from excessive losses. If your stock selection doesn't work out and you're faced with a loss, don't let your pride stop you from admitting you've made a mistake and acting quickly. Cut your losses early and move on. You must make rational decisions, instead of trying to rationalize your way out of a costly mistake.
It's not just your own personal opinions that can be wrong। Analysts or market commentators can be just as erroneous, and basing your decisions on their opinions can often lead to disastrous results. Investors often buy loser stocks, justifying their decision with remarks like, "All these Wall Street analysts are saying great things about this company," or "This technology is the greatest thing since sliced bread. The market doesn't realize it yet, but it's bound to become a household item." Famous last words.
Cut Your Losses Early
The first rule is sell any stock that falls 8% below your purchase price. Why 8%? Because research shows stocks showing all the right fundamental and technical factors in place and bought at precisely the proper buy point (which is explained fully in the "Using Stock Charts To Round Out Stock Selection" lesson of the stock buying course) rarely will retreat 8%. If they do, there's something wrong with them.
You may think a stock is due to rebound. But the market could send the stock to lower depths regardless of your views or what analysts and commentators say on TV. No excuses, no alibis. You may want to sell even before an 8% loss if you see other signs of weakness in a stock (we'll explain these throughout this course).
This rule emphasizes the importance of buying at the right time. If you don't and you buy a stock that is overextended (that's reaching the end of its climb), chances are it will hit the 8% sell level as it goes through a normal pullback. Make no exceptions to the rule. The best stocks will always give you other opportunities to buy. Here's another way to look at it: Once a stock falls 8% below your cost, does it still look attractive? Is it still among the best stocks? Probably not. There's no guarantee that it will go back up, and you need to protect yourself.
The bigger the fall, the harder it is to recover. Say you bought a stock at $100 a share. It falls 20%, to $80. To get back to $100, the stock has to make a 25% gain. Another example: The stock plummets 50%, to $50 a share. It would take a 100% jump to get it back to $100 — and how often do you buy a stock that doubles? And if it does, how many weeks, months or even years does it take to get there? Wouldn't you rather cut your loss early, and free up money to purchase another stock with better chances of doubling?
Of course, it could happen that you sell a stock that falls 8%, and then watch it go up afterward. But you have to think of the 8% sell rule as your insurance policy against catastrophic losses. The rule will in effect limit any losses on your portfolio to no worse than 8%.
Nevertheless, if you've bought a fundamentally sound stock at the right point, (explained in the stock buying lessons) it will rarely plunge 8% immediately। Buying exactly right will solve half your selling questions।
How Cutting Losses Helps You
Below are a set of hypothetical trades to illustrate how cutting losses can boost your portfolio.
As you can see, even if you had made these seven trades over a period of time — and taken losses on five of them — you would still come out ahead by more than $3,700. That's because the two stocks that worked out resulted in a combined profit of $5,500. And the five losses — all capped at 8%, except for one that was cut early at 7% — added up to $1,569.
You see the point? It would take several 8% losses to wipe out the profit from just one or two good stocks.
Stock Shares Cost/Share Sell Price Profit/Loss %Profit/Loss A 100 $50 $46 -$400 -8% B 100 $43 $40 -$300 -7% C 100 $57 $98 $4,100 +72% D 50 $24 $22 -$100 -8% E 30 $110 $101 -$279 -8% F 70 $85 $78 -$490 -8% G 100 $65 $79 $1,400 +22% Total $3,731
The 8% Rule Applies Only To Losses From The Purchase Price
The 8% sell rule, however, applies only to drops below your purchase price and does not apply to situations where you've already made gains on a stock। A part of being a stock investor is weathering temporary sell-offs that may be 8%, 10% or even larger. The next two lessons will teach you how to, in most cases, tell the difference between one such dip and a real problem.
Dealing With Hyperactive Stocks
About 40% of stocks pull back close to their buy point for one or two days. This is not the time to panic and sell, especially if the stock was purchased as it came out of a sound basing area at the right buy point. (For more on this, check the chart-reading lesson of the stock buying course) As long as the price doesn't drop 8% below the point at which you bought, you should, in most cases, hang on through the first pullback.
Watch how the stock performs relative to the general market and its industry group peers. Often, a stock pulls back close to the buy point for one or two days because the general market has temporarily pulled back. This is normal. On the other hand, if the market has been rallying over several days and your stock hasn't come to life, then this might be a warning sign, even if the stock hasn't dropped 8% below your purchase price.
Another thing to ponder: Stocks with 98 or 99 Relative Price Strength Ratings are usually more volatile, increasing the chance of slipping 8%, particularly if you buy them extended in price beyond the exact buy point।
Stop-Loss Orders And Other Considerations
Some investors like to use stop-loss orders, which are instructions to brokers to sell a stock at a predetermined price. This might be useful for those who can't watch their stocks closely or for those of us who may be less decisive.
Also, tax considerations and brokers' commissions should rarely enter into your sell decisions। You shouldn't always hold a stock for more than a year just because you'd pay a lower tax rate on the profit. And with lower commissions today, they should not be the most important factor. Your main goal should be to obtain and nail down gains.
Holding Losers In Your Portfolio?
You may be looking at your portfolio and seeing there's some stocks already 8% below your purchase price — or worse। Should you sell them? Probably, unless a stock is showing strong signs of recovery, such as a rising stock price on solid trading volume and improving earnings. Even then, there is no guarantee it will rebound, and the chances are it could go even lower. The greater the loss, the greater the chance of it developing into a really serious loss.
Key Points To Remember
- The first sell rule is to get rid of any stock that falls 8% below your purchase price.
- It's critical to follow this loss-cutting rule regardless of how highly you value a stock. Personal opinions get in the way of smart selling decisions.
- The larger the loss, the higher the recovery you need to get back to the break-even level. (A 50% loss on a $100 stock, for example, requires a 100% gain to get back to $100.)
- Strong stocks sometimes initially retreat close to their buy point (as determined by the stock's chart pattern). This doesn't necessarily mean you have to sell, unless the stock goes 8% below the purchase price.
- Avoid making sell decisions based on tax concerns or commission rates ।
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