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Stock Selling Strategies
Cut Your Losses Short
by Marco den Ouden

"Even being right 3 or 4 times out of 10 should yield a person a fortune if he has the sense to cut his losses quickly on the ventures where he has been wrong."

- Bernard Baruch

Did you ever buy a stock you were sure was going to be a winner only to watch it drop right after you bought it? So you think, "Hmm.. I'm sure this stock is winner. The fundamentals are right. The momentum was right. I like the company's products. I'll just hang on and give it room to recover."

But it drops further. So you think, "Hey. How low can it go? It's got to start moving up again sometime." So you wait. And it drops further.

There are two problems with hanging on to a stock that's gone down since you bought it. One: the stock may be declining for some reason you're not aware of and may never go up again (or take a darn long time doing so.) and Two: the money invested in this stock could be invested in something else that's going up.

  In his best-selling book, How to Make Money in Stocks, William O'Neil compares the situation to running a business, say a store selling women's fashions. If the store is selling a line of dresses in three colors, red, green and yellow, and the red ones sell out quickly, half the green ones sell, but the yellow dresses don't move at all, what does the merchant do?

Does she order more yellow dresses? Does she tie up more money in inventory that is not selling? No! She puts the yellow dresses on sale. And she keeps slashing prices to get rid of them. She wants to get her money out of the "dogs" and put them into buying more of the hot sellers.

Well, investing is a business too. And if your stock is a dog,

sell it and move on.

Yet this is probably one of the hardest things for an investor to do. Many, if not most people, get emotionally involved in their stocks. If "their" pick does not pan out, they do not want to admit failure and defeat. They want to hang on and be vindicated. Yeah! I'm smart. My stock came through after all!

But it is not a reflection on you at all. A stock does what a stock's gotta do. If the market dictates that the stock go down, even though you're sure it should be going up, don't argue with the market. Don't take it personally.

The business woman doesn't take it personally that her yellow dresses aren't selling. She takes action to rectify the situation. So should the investor.

The Recovery Trap

There is another reason you should take losses quickly if they develop, and that is the ability to recover losses. If a stock drops 10% from the purchase price, you can make it back with an 11% gain. If it drops 20% you can make it back with a 25% gain. But if it drops 50%, your stock must gain 100% just to break even! Check out the table below for the sobering numbers.

Amount Stock Drops Gain Needed to Break Even
5% 5.26%
10% 11.1%
20% 25.0%
30% 42.86%
40% 66.67%
50% 100%
60% 150%
70% 233.33%
80% 400%
90% 900%

When you consider that a 25% return on investment is considered a good return, and how rare it is for a stock to gain 100%, let alone 900%, it should give one pause as you watch your favorite stock keep dropping.

During the NASDAQ rout of March and April 2000, many stocks dropped 50% to 90%. Many will never recover their former heights - or certainly not soon. The poor sap who bought at the top of the market would have saved his bacon by selling quickly when the market turned. In fact, he could have bought far more shares of the same stocks after the market bottomed than he would have had by hanging on.

How Big a Loss Should You Take?

William O'Neil recommends selling any stock in which you have developed a loss of 7% or 8% of your cost. He emphasizes that this should apply only to stocks in which you have developed a loss. He does not mean you should sell stocks which are ahead but which have dropped 7% or 8% from their peak. Once you are in a profit position, you can give the stock some more leeway in price fluctuation.

The editors of the Cabot Market Letter, Timothy and Carlton Lutz, recommend selling immediately if you've sustained a 20% loss. It is not unusual for their newsletter to issue a sell recommendation on a stock they only recently recommended. On the other hand, they believe in letting their winners run. They, like O'Neil, are more tolerant of fluctuations in the price of a stock in which they are ahead.

Henry Ford (no relation to the auto Fords), the developer of The Pitbull Investor, a modified CANSLIM approach to investing, emphasizes the point. "Always know before you invest what the triggering event will be to get you out," he says. He recommends not accepting more than a 5% to 10% loss on any individual investment. In fact, he even recommends placing hard limits on how much of a drop from a stock's peak price you should accept.

Downside to Cutting Losses Short

The only real downside to cutting losses short is that the stock you just sold may turn around on a dime and go straight back up again. It may be annoying, but not nearly as annoying as watching the stock fall further.

In any event, you're not rolling over and playing dead. Once you've gotten your money out of a losing stock, you should be looking for another opportunity to put the money back to work again.

AND... there's no reason you can't buy back into the same stock again when it recovers. You may even be able to do so at a lower price.

Summary of Advantages and Disadvantages
of the Cutting Your Losses Short Strategy

Advantages Disadvantages
Preservation of capital. You're taking a loss.
Money not tied up in a stock going nowhere. Hey! It may go up again!
Peace of mind.  

Other Links of Interest

Investing Basics: How to Sell a Stock - from Investors Business Daily.

Selling Stocks: Do You Want to Feel Right or Make Money? - from The Cabot Newsletter Group

The Pitbull Investor - This is a modified CANSLIM approach to investing.

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