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Learning to Limit Investment Losses

It's never too late to cut and run.

Everyone knows the analogy of the frog in boiling water. I think it’s stupid, but instructive.

After all, when I’m in a hot room, I can definitely tell when it’s gotten too hot, and get out.

But, not all frogs are as smart as me I guess.

The sad thing is, most investors seem no smarter than the frogs. When the pot they’re sitting in gets too hot, they don’t do anything—they just sit there and boil to death.

Let’s say you’re in a bad trade. You were sure the stock was set to skyrocket. But you were wrong... and the trade has moved away from you. Human nature immediately kicks in... you begin to justify keeping the trade on, even though it’s beyong the bounds of your theory. You begin to imagine impossible scenarios that could still possibly allow the trade to play out... maybe. You wait overnight. It’s over. You throw up your hands and exclaim, “Well, I guess it’s too late now. Might as well sit on it.”

Congrats. You just joined the myriad average investors that don’t know how to keep small losses from becoming catastrophic failures.

Here’s some advice that will ensure you’re never frozen with hesitation when it comes to investing and trading.

Knowing the end from the beginning

Here’s the plan: always know the end from the beginning. From the second you buy, determine when you’ll get out on the downside, and how far you’ll let your winners ride on upside.

My “investing” tuition has been more expensive than I wish it was. I’ve made a lot of mistakes both up and down—selling way too early and giving up potential gains, and selling way too late for losses that were too big to stomach, literally.

Human nature is ridiculous. When we’re doing well, we think we’re invincible. We tend to focus on upside, and fear missing out more than we fear giving up what we already have, or losing completely.

If it’s happened to you in the past, never let it happen again.

Planning an exit strategy should forms an integral part of the overall process that gets you into the trade in the first place. For example, if you’ve decided that a stock trades within a certain range, you should also know the range that it shouldn’t be trading outside of... and in theory you take that range as a caution or “sell” zone.

I’ve written before before about the necessity of banishing emotion from your investment process. Nothing is more critical to successfully executing your exit strategy than this. I like to analogize my investment account as a machine programmed with methodogies, conditions, and triggers.

Once a condition is met, the machine kicks in and executes ruthlessly.

Let’s be clear—one of the reason poor investors stay poor is because they don’t cut their losses. The other is that they cut their winners early. The trailing stop helps alleviate this second problem.

Trailing stops help to limit losses

Now, on to specific strategy. Personally, I abide by the 4/20 rule. I invest no more than 4% of investable funds into one investment (why 4%? Because no portfolio should have more than 25 holdings) ... and I cut my losses at 20% from the purchase price. If I bought Apple (AAPL) at $100, and it goes nowhere but down from there, I sell at $80 with extreme prejudice.

However, if AAPL runs up to $120 first, I sell at $96 (120 x .80 = 96). Huh? That’s only 4% right? This may be a new concept for you. It’s what’s referred to as a trailing stop.

A trailing stop is constantly adjusted by making your “purchase” price be the highest price the stock has attained since you bought it.You can find out what the trading range for a stock has been since you’ve owned it by pulling up a chart in your brokerage account or by going to Yahoo Finance. Simply enter the symbol and the date you bought, and trace the chart’s highest price movement.

Here’s another tip. I’m extremely conservative. I like to make sure that if a stock has risen a lot since I bought, that I don’t give up much of the gains before selling. I tend to adjust my trailing stop to 10% off the high if the stock has risen by 20% or more. This ensures that the minimum gain I make on a high-flyer is 8%--a respectable return.

A quick note: don’t trade off intraday prices. Things can whipsaw all over the place on crazy days. Go off daily closing prices. Whatever stop you set, if it’s hit and closes below it, sell the stock next trading day.

Take a look at this chart. It will absolutely blow your mind. Imagine you are sitting on a 90% loss of capital. I hope you’ll never think about this principle the same way again.

I’ll reiterate the poor investor’s woes here again: Investors stay poor by not cutting their losses, and by not letting their winners run. You’ll do well to internalize these rules.

Live long and invest,

Jeremiah

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