One of the most popular phrases you will hear on Wall Street is to cut your losses short. Even though this is great advice, most investors ignore it. They still sell their stocks after they had made only a small gain, watching those stocks get higher or they hold onto a stock after a small loss only to watch those losses get worse. Nobody of course deliberately purchase the stocks that they think are going to become worthless or go down in price. But buying stocks which drop in value is something that every investor will face. The objective, that said, is to not avoid the losses but to simply minimize them. You want to realize a capital loss before it becomes out of hand. This is what will set you apart as a successful investor.
When it’s time to let go
In spite of the logic behind cutting your losses short. Many of the smaller investors out there still end up holding on to stocks that have unrealized losses. In the end they have a lot of stock positions with lost capital. At best this is considered dead money and at worst it continues to drop until it never recovers. Today, investors believe that the reason there are many unrealized losses is simply because they bought the stock at the wrong time or they just faced a really bad bit of bad luck. Most people refuse to believe that the reason they have such big losses is because of their own behavioral bias.
If you want to know the right time to cut your losses, you have to be willing to look at these behavioral biases.
Stocks don’t always bounce back – why use trailing stops
If you look at a long-term chart for major stock indexes you will see that most lines move from the lower left corner to the upper right. Over a long period of time the stock market always makes new highs. Knowing that it goes higher, investors usually make the mistake of assuming that when something happens and their stocks drop, eventually they will bounce back. But understand that the stock index is comprised of successful companies, that line that you see heading ever for word and up is an index of winners. The stocks which were less successful might have been listed on that index at one time but if their value drops then they get replaced by more successful companies. These indexes regularly replenish themselves by getting rid of losers and replacing them with winners. Therefore, individual stocks and companies do not always bounce back. In fact, lots of companies never regain the highs that they once had an end up going bankrupt.
Admit that you’ve made a mistake if you avoid selling your stocks at a loss then you don’t have to admit to yourself that you made up big mistake. But making mistakes is not the worst thing in the world. If you have the proper exit strategy and you planned the amount of risk you were able to take, simply choosing to cut your losses means that your plan worked and that you have learned something from this mistake. You don’t want to avoid admitting you made a mistake just because you don’t want to face the reality. Once your stock suffers a loss, you might want to hold onto it until it returns to its purchase price and then recover it but this doesn’t always happen. Sometimes stocks just continue to slide down.
Don’t neglect your investments: use a stop limit order
When stock portfolios start doing well, investors will usually leave them be. Just like when your garden starts to blend you stop caring about all the weeds that you once removed, when people get comfortable with trading they tend to neglect their stocks. They lose interest when stocks start holding steady or dropping for a long period of time. If you let this happen in your stock portfolio will begin to show the signs of neglect. You have to regularly bleed your garden of investments by getting rid of the losers. Don’t let things spiral out of control. On that note, hope is a very dangerous thing to have. A lot of people hope that a positive outcome will happen even if there is evidence to the contrary. People hope that bad news is only temporary and they hold on to losing stocks. Hope has no place in the investment world. Do not let your emotions get the better of you when you are making your traits. Trade wisely. Every business probably has some sad story or a really enthusiastic owner who swears that things will bounce back. They are falling victim to the same type of hope. If you see that things are taking a turn for the worst and there is evidence to support that it is going to continue, cut your losses. Make a smart business decision. The decision to hold onto stocks based on hope negates all of your rational analysis and all of your trading strategies. Hoping and wishing that stocks go up doesn’t make it happen.