Thursday, January 10, 2008

Profit by Controlling Your Stock Market Losses

When managing your stock portfolio, do you get upset by positions which go badly against you? What can you do and how should you look at losses in your portfolio.

Jim Cramer's View

Jim Cramer, in his Book, "Real Money: Sane Investing in an Insane World" presents his Seventh Commandment of Trading: Control your Losses.

"Losses do you in. They always do you in. Controlling losses is the most important thing you can do. I don't really care how you do it. If it is to put on stops in trading, then so be it. If it is to decide that you are never going to let a position run a point against you, then fine. But you must heed the seventh of my 10 Commandments of Trading:
Control losses; winners take care of themselves."
- Jim Cramer

While Jim Cramer was talking about trading, the same concept applies to longer term investing.

Peter Lynch View

Peter Lynch, in his book "One Up on Wall Street" (page 75, paperback edition):

"People who succeed in the stock market also accept periodic losses, setbacks, and unexpected occurrences. Calamitous drops do not scare them out of the game. If they've done the proper homework on H&R Block and bought the stock, and suddently the government simplifies the tax code (an unlikely prospect, granted) and Block's business deteriorates, they accept the bad break and start looking for the next stock. They realize the stock market is not pure science, and not like chess, where superior position always win. If seven out of ten of my stocks perform as expected, then I'm delighted. If six out of ten stocks perform as expected, then I'm thankful. Six out of ten is all it takes to produce an enviable record on Wall Street." - Peter Lynch

Imagine that, all you need is six out of ten stocks to do well. That means even great investors such as Peter Lynch do make mistakes.

William O'Neil's View

Growth stock investor William O'Neil, founder of Investors Business Daily, often has sell rules such as sell when a stock goes down 7-8% below the proper buy point, or sell at a certain percentage down. He too has a discipline, to make sure his losses do not grow and ruin the portfolio. He also does not "marry" or become "attached" to a stock, a common mistake some investors make.

Investor's Business Daily mentions that "being a successful investor is just as much about limiting losses as it is about riding a winning stock. Downturns are part of life in the market, and you must act decisively to shield yourself form 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 activing 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."

Wall Street Saying: Cut your Losses Short and Let Your Winners Run

All the comments above reflect a common Wall Street Saying regarding Cutting your Losses short and Let your winners run. This is what every investor should do, but it often turns out that some investors do the opposite. They take profits quickly, and allow losses to start growing.

So don't forget to Control your Stock Losses!


Anonymous said...

This strategy does apply to mutual fund?
In investing in mutual funds the strategy is to invest when the funds drop. In a given month the stock will raise;even in a down market.It is possible to make money using this strategy.

techfarmer said...


Good question about mutual funds.

If the mutual fund is a diversified index fund, and if you truly are investing in the long term (10 or more years), and if your entire portfolio is appropriately diversified and matches your risk profile and your goals, and if you believe in the long term ability of the stock market to grow your money, then yes, the strategy of adding to the index mutual fund is a good strategy.

There are similar strategies such as dollar cost investing where you invest regularly in a mutual fund whether the market is up or down.

However, if you are invested in a bad actively managed mutual fund, then at some point, you have to decide whether it is worth investing in that fund at all, and not continue to accumulate that fund.