Cut Your Losses

One of the fundamental rules of stock trading is to cut your losses and let your winners run. Stock “trading” is for short-term buys and sells, but this rule can also be applied to stock investing. The idea is that minimizing your losses makes it easier to grow your account.

There is a mathematical fact that works against investors. If an account loses 50% of its original value, then it must double from that point to get back to the original amount.

Original: $100,000
50% loss: $50,000
100% gain: $100,000

Obviously, gaining 100% to get back to break even is a difficult thing to do and will take many years if not over a decade. Hopefully you can see that if we didn’t lose the 50% we would be in a better position. It is far easier to recover from being 10% or even 20% down than it is from 50% down. Limiting our losses should be a major focus. Traditional investing doesn’t do this however. They suggest holding on through all the downturns.

If we are limiting our losses, the solution to a downtrend is for us to sell our positions. At first glance, that may sound like an unorthodox idea. Afterall, aren’t we supposed to be invested?

If we sell before a large decrease, then we are keeping more of our previous gains. If we are in the stock market during the good times and out of the market when its going down, then we won’t have large decreases in account value to overcome. Limiting losses is the key to overall portfolio gains. When you limit your losses, you do not have to spend as much time trying to get your account back to its previous high.

A strategy that gets you in and out of the market is called active management. By following a set of rules that tell us when to sell and when to buy, we create a system that can be tested and proven to work over previous market cycles. Similar to a diet and fitness plan that leads to weight loss and increased strength if we follow the schedule. Following a proven system helps remove the mistakes that come when we are emotional or making decisions aimlessly. It helps decrease the likelihood of selling at the lows and buying at the highs. If our rules are good and we follow them, then we make money over time.

For more information about active management strategies or to find out if they are right for you, contact us at (760) 651-6315.

 


Cut Your Losses
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