Cutting losses quickly should be the first lesson that every person should learn before starting investing or trading on the stock market. This is by far the most important lesson since capital preservation is a must! If you lose all your money then you are out of the game.
Have a selling plan BEFORE buying a stock
Every Investor is eager to buy stocks, but the vast majority of those buy stocks without having a plan on mind, if you buy ABC Inc at a share price of $10, would you still hold the stock if it drops to $9.50 (5% decline)? What about if goes now to $8.50 (15%) per share?
You should do a study of how to stock behaves, what is the volatility of the stock (Beta), what is the usual fluctuation of the share price (1% each day? 0.5%?) and set a share price at which you will get out of the stock no matter what.
The share price might go up again, if this happens, reassess the company and look for a new entry point and don’t feel bad about it. If the share price keeps declining, you just saved yourself from losing more money
Everyone makes mistakes!
Please read this and say it loudly “I will make mistakes” and realize that mistakes will happen, that the hidden gem that you bought is now tanking hard and it was not the super company you expected to be. Making mistakes is not the problem, the problem is being stubborn and holding the stock at all cost. No stock is worth more than your sanity and health
Even the best baseball batter will get striked out, but they will still continue hit ball and make a home run on a constant basis! We as investors/traders have to acknowledge this fact and set our ego aside and sell the stock at loss quickly!
Hold and hope is NOT a strategy.
Human nature is an interesting thing. The majority of Investors are quick to sell for profit but slow to sell at loss, and this is due to the fact that if you sell at loss you are recognizing that you made a mistake.
If your ABC Inc shares that you bought for $10 suddenly losses 10%, you will need it to go up by 11% just to break even (without the associated fees), if it drops by 20%, now you will need it to go up by 25%, and if the share price drops by 50%, you will need the stock to go up by a 100% just to break even? If you follow closely the stock market you will realize that this doesnt happen often, and if you are lucky to break even, it might take years for it to happen
Don’t keep adding more shares if the price keeps declining
This is a very common misconception. You will hear on the news “By more ABC shares!, price dropped by 15% and its now an absolute bargain!” and you will probably be sitting with a paper loss and you decide to buy more shares because it is a “discount sale” and it will help to average down your share price
We have to realize that a stock is NOT a pair of shoes. A discounted pair of shoes during black Friday sale will be the same pair of shoes as they were before the sale, but a stock that has a decrease on the share price and that every week keeps going down, is now a company which fundamentals have changed considerably, this company is no longer the same company it was when you initially bought the shares. Do NOT keep throwing your hard earned money to a losing position.
Valeant Pharmaceuticals (VRX) – Study Case.
Valeant Pharmaceuticals is a pharmaceutical that was well known for it rapid growth due to acquisition and in order to proceed with the acquisitions, the company had to constantly issue more debt and eventually the debt was so high that the company couldn’t keep with it (there were more reasons)
You might see Valeant’s chart below and wonder “It’s very evident that the company was in trouble” and yes, there were clear signs of trouble, but if you were used to see the stock price rising for years and years and suddenly see a 10% drop, you might be real tempted to buy more shares since it now a steal for 10% discount! “Buy more shares, you will never see this price again”… and yes, we are still yet to see those prices…
Like Warren Buffet says “Be fearful when others are greedy and be greedy when others are fearful”, investors had to analyze why the share price was declining instead of buying more shares, or better yet, selling a portion or all of the position if the company was on real trouble. One of the stubborn money managers that forgot about this principle was Bill Ackman, and it costed him and his clients USD$4,000 Millions, he probably never thought he was wrong or couldn’t accept the fact that he was making a big mistake.
Cut your losses quickly!