Why we need to learn how to cut losses
Selling a losing stock or cutting losses is never easy. When we sell a losing stock, we throw away the hope of making money in case the stock rebounds someday. We also admit that we were wrong in buying the stock which is never an easy thing to do. Nevertheless, learning how to cut losses is one of the most important lessons we need to learn to improve our investment returns.
One of the reasons why we should cut losses is the possibility that a company’s fundamentals are no longer the same. For example, film cameras have become obsolete now that everyone is taking pictures with cellular phones. This has hurt the earnings of Kodak, once a very profitable company and a good stock.
Another reason why we should cut losses is to free up capital so we can take advantage of better opportunities. Everyone has limited funds to invest. By selling our losing stocks, we free up some capital to invest in other stocks that can go up faster compared to our losing stocks either because they have better fundamentals or they are currently in play.
Finally, cutting losses gives us a psychological boost by healing us from the pain of losing money. After all, there’s nothing more depressing than seeing losing positions in our investment portfolios on a daily basis especially when the losses are north of 10 percent. Because of these losses, we have a tendency of becoming unreasonably risk averse. This hurts our ability to think objectively. Worst of all, this makes us hesitant to buy stocks when the opportunity to make money finally arrives.
Although cutting losses is difficult, below are some tips that can make the process easier.
For traders, never buy a stock without planning where to cut losses assuming that prices don’t go your way. By planning ahead, you avoid the risk of having significant losses on your trades. After all, you don’t need to be right all the time to be a successful trader. You just need to limit your losses when you are wrong and maximize your profits when you are right.
Resist the temptation to buy stocks based on rumors or tips in hopes of making huge profits quickly. Most of the time, these high flying stocks go down as fast as they go up. Worst of all, liquidity of these stocks dries up when they are no longer in favor making them almost impossible to sell without incurring significant losses.
Assuming though that you already own a stock that is losing money, be honest and ask yourself why you bought the stock in the first place. If the reason for buying the stock no longer exists, then you should not hesitate selling the stock.
You can also ask yourself this question: Assuming that you don’t own the stock, would you still want to buy the stock today? If the answer is no, then there is no point of keeping it.
Some of you may want to take your time in selling a losing stock because you don’t need the money right away and can afford to wait for the stock to turn around. There is nothing wrong with this.
However, you should prepare yourself mentally to sell your losing stock assuming that you find another stock that you would rather own. By switching to a stock that can give you better returns faster, you are enhancing your returns. You can always buy back the losing stock that you sold once the new stock that you bought makes money.
Finally, the size of your loss should not determine whether or not you should sell a stock. Although it’s painful to realize losses of 50 percent or more, sometimes you just need to cut your losses to move on. Like other expensive mistakes, consider it as tuition in the school of life.
