One of the many words of wisdom told by Warren Buffett is “Rule No. 1: Never lose money. Rule No. 2: Don’t forget rule No. 1”. Unfortunately, this is easier said than done. At some point, there’s a possibility that you may lose your hard-earned money from a bad investment.
Cut Your Losses Short
No one will deliberately buy a stock they believe will go down in price and be worth less than what they paid for it. However, buying stocks that will eventually drop in value is inherent to investing. Avoiding losses entirely may not be possible. A successful investor accepts losses and will try to minimize their losses rather than avoid them.
This means selling a stock when it’s down 7% or 8% from your purchase price. Sounds simple, but it takes emotional discipline to admit that you have made a judgement error and to cut your losses short to prevent you from suffering a devastating fall that’s too steep to recover from.
The tip to remember when calculating return percentages is that the calculation always goes from the starting point to the ending point, with the starting value as the base. For example, an investment is worth $100. If it goes up 10% it will be worth $110. A drop of 10% puts the investment at $90. The 10% is based on the $100 start. After the 10% loss, the new starting point would be $90. Since it takes a $10 gain to get back to $100, 10 divided by 90 shows that, in this case, it would take an 11% gain to recover from the loss.
Big Losses are Harder to Recover
After a stock suffers a loss, many investors plan to hold onto it until it returns to its purchase price. They intend to sell the stock once they recover this loss. This means they will break even and “erase” their mistake. Unfortunately, many of these same stocks will continue to slide. When your stock drops 30%, to get back even, you need a 43% gain, which is much tougher to come by than that easy 11%.
What if the market really doesn’t like your stock and slices it in half to 25? You don’t need a calculator for this one: To recover a 50% loss requires a 100% gain. How many stocks did you pick last year that doubled in price?
The Bottom Line
No one wants to suffer a loss of any kind, but you need to remind yourself that a lot of other people out there took a hit just like you did—perhaps even more of a hit than you did. Often you just have to bite the bullet and sell your stock at a loss early before those losses get bigger.
Hoping that the stock will bounce back is not a strategy, and an investor need to have a logical reason to hold a losing position. What you paid for a stock is irrelevant to its future direction. The stock will go up or down based on forces in the stock market, the stock’s underlying fundamentals and its future prospects.
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