Why learning to cut losses is important

It’s been more than 20 years since I started investing in stocks.

One of the most important lessons I’ve learned early on in my investment journey is to cut losses.

Even though I try to know as much as I can about a company before I buy its stock, I also make mistakes. After all, I don’t know everything, and a lot of unforeseen circumstances can take place, hurting a stock’s performance.

There are many reasons why learning to cut losses is important.

For one, it takes much larger gains to recover losses. For example, if a stock goes down by 10 percent, it needs to go up by 11.1 percent for you to break even. If you wait for the stock to go down by 50 percent, you need to wait for it to go up by 100 percent before breaking even.

You may argue that losses are only realized if you sell your stock, and there is always hope of recovering losses as long as you still own the stock.

However, there is also a possibility that the stock you own will remain depressed for a very long time, depending on the reason why it went down. Note that there are a lot of stocks today that are worth much less than what they were many years ago because times have changed and the company isn’t doing well anymore.

Be honest and ask yourself if you would still want to buy the stock you are holding today if you didn’t own it right now. If the answer is no, then there is no reason why you should still be keeping it.

Another reason why you should learn to cut losses is to free up capital. There is an opportunity cost in holding on to losing stocks because it limits your ability to buy better performing stocks.

Rather than waiting for the stock you own to go up, you might be in a better position to recover your losses faster if you switch to other stocks with better growth prospects.

Also, markets go through rotations. A sector that was in favor before might no longer be in favor now, either because of valuation or new developments that would benefit other sectors in the market more significantly.

For example, banks and property stocks, which were among the worst performers earlier this year, are now performing very well because they would benefit the most from the economy’s reopening.

Finally, cutting losses will help you psychologically invest more profitably.

Misery loves company. Losing money is painful, especially when losses are huge, which is common during bear markets. When you have been holding on to losing stocks for a long time, you would rather believe that the market is weak so that you can blame it for your poor performance.

Unfortunately, the emotional impact of your losses will make you unreasonably cautious and prevent you from buying stocks when the market is already turning around. After all, it is emotionally difficult to buy stocks when your portfolio reminds you of how unlucky you have been so far when it comes to investing.

Cutting losses early will help you clear your mind and think objectively. This will allow you to participate in the bull market when it finally comes. And investors who participate in the bull market early enjoy the most significant gains. INQ