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Rules for Taking Stock Market Losses

Original post by Slav Fedorov of Demand Media

There are no hard-wired rules for taking stock market losses, but an investor can follow several useful guidelines and time-tested common sense practices to protect his portfolio in a bad market and maximize the upside while minimizing the downside in a good one.

Contents

Taking Losses

The first step is to accept that stock market losses are inevitable. They cannot be avoided but they can be managed and minimized. Investors must be mentally prepared to take losses as necessary without procrastinating, rationalizing or bending their own selling / loss cutting rules.

Capital Preservation

An investor's first line of defense is capital preservation. If he loses 20 percent, he must make 25 percent just to break even; if he loses 50 percent, he must double his money to break even. Those who lose the least often fare the best in the long run. If an investor loses his capital, any investment strategy is worthless because he can't implement it. If an investor takes a loss to preserve his capital, he will be able to take advantage of the next market opportunity.

Admit and Correct a Mistake as Soon as You Realize You Made One

The only thing that proves one is right in the stock market is when an investment shows a profit. If an investment is showing a loss instead, something is wrong. Assigning blame or looking for a culprit won't turn a loss into a profit. The only thing to do to correct a mistake is to take the loss and start looking for another opportunity.

Cut Losses Early, Let Winners Run

Stock traders say that the first loss is the best loss. The sooner an investor cuts a loss, the smaller it usually is. If a disciplined investor invests in individual stocks, he can be right less than 50 percent of the time and still make money if he follows this rule. For example: an investor divides his portfolio equally among five stocks. The first stock doubles, the second does not do much, the third, fourth and fifth decline, but if the investor sells the losers at a 10 percent loss each, he is still ahead overall -- with just one stock out of the five he bought. If the investor lets his losses grow bigger, they will eventually cancel out his gain in the first stock and push him into the red.

Loss Cutting Guidelines

No one Investment should materially hurt an investor. The only way to avoid a catastrophic loss is to limit exposure to any one investment vehicle no matter how good it looks, whether it is individual stocks, exchange-traded funds (ETFs) or mutual funds. A certain amount of fluctuation is normal and expected, but at some point a loss must be cut. It's best to set a loss-cutting limit at the time of purchase. Some traders never risk more than 2 percent of their capital on any one trade; many traders cut losses in individual stocks at 5 to 10 percent. If an investor divides a $50,000 portfolio equally among five carefully selected stocks and limits his loss in any one stock to 5 percent, the maximum he can lose in a stock is $500, and his total loss from all five will not exceed $2,500.


                   

References

  • "How to Make Money in Stocks"; William O'Neil; 2009
  • "Stan Weinstein's Secrets From Profiting in Bull and Bear Markets"; Stan Weinstein; 1988
  • "Trading for a Living"; Dr. Alexander Elder; 1993

About the Author

Based in San Diego, Slav Fedorov started writing for online publications in 2007, specializing in stock trading. He has worked in financial services for more than 20 years, serving as a banker, financial planner and stockbroker. Now working as a professional trader, Fedorov is also the founder of a stock-picking company.


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