Cutting Your Losses

September 28, 2007 at 10:44 pm · Filed Under Educational 

Let’s say you had a choice between picking stocks correctly 40% of the time where you make 50% when you’re correct and lose 10% when you’re incorrect or picking correctly 60% of the time where you make 50% when correct but lose 50% when incorrect. What’s your choice? To figure out which is better, let’s create a scenario where we do 10 trades of $1000 each, and the statistics work out perfectly. For the first option, you’ll be correct 4 times to make $2000 and you’ll be incorrect 6 times to lose $600 for a grand total of $1400 of profit. For the second option, you’ll be correct 6 times to make $3000 and you’ll be incorrect 4 times to lose $2000 for a grand total of $1000 profit. Somehow, our method where we picked correctly less than half the time ended up beating the method where we picked correctly more than half the time by $400. If you stretch that out to 100 trades at $10,000 the difference turns into $40,000. So what was the difference in the equation here? It was only the fact that we cut our losses at 10%, accepting a lower number of correct picks and missing out on a couple that would have come back.

Typically when people purchase a stock that starts losing money, they’re very reluctant to sell it. Some people go by the theory that it’s not a loss until you sell it, so they’ll hold on in order to keep their ego intact (“I wasn’t incorrect on that stock because I haven’t booked the loss yet”). This is a ridiculous way of looking at things since that money is already lost and gaining it back on the stock you’re holding is the same as gaining it back on a different stock. Margin accounts are marked to market every day for the same reason, since brokers realize that the value you lost on an unsold stock is no good as collateral anymore too. Once you start falling into the trap of hoping your stock will bounce back, you never know when to stop. I know people who’ve watched stocks lose 98% of their value because every time it dropped, they kept thinking it was the bottom. Sure, every once in a while, you’ll have one or two bounce back and you’ll kick yourself for selling them at the bottom, but looking at the numbers above you’ll see you can afford to miss those few here and there. Something else that isn’t reflected in those numbers is the opportunity costs you’re losing by holding onto a stock that’s going down too, which is actually the greater reason for cutting losses short. I’ve also found that when I’ve sold at the bottom, the new stocks I’ve bought with that money often times do as well or better than the one I just sold (since it usually rebounds due to a change in the broader market conditions), so the amount lost by selling early is much less than you normally think.

So am I recommending that you always sell stocks once you lose 10%? Unlike O’Neil, I don’t believe you should set a hard limit like 7%, but I think you should look at the support levels and know where you’ll sell the stock before you even buy it. Let’s look at a breakout purchase as an example to get a better idea of what I’m talking about, keeping in mind that the same principles can be applied to any other types of purchases you would make too (swing trades, bounces, etc).

This is Microsoft around the turn of the century. From 1998 through 1999, they rose from around 15 up to the point you see here. If I were to evaluate the stock around point 1, I would see the uptrend and the resistance around 42.50. Right at the end of 1999, I might have bought the breakout and I would have several choices on where to set my stop. I could either pick my breakout price, around 42.50, or I could keep moving my stop up to match the trend line along the bottom. Of course, depending on my confidence in the stock and the general market conditions, I would set my actual stop a little below those numbers, increasing the amount of leeway I would give it to match my sentiment. As it turned out, if you didn’t take any profits after the stock went up 20% and fell back down, you would have had a pretty clear sell signal at point 2 as the stock fell through both of those sell points. Not selling at this point would have seen a loss of more than 50% (and almost a year of opportunity costs) at the worst and 30% (and probably a few years) at the best.

If you have the discipline to sell the stock once it falls through your predetermined sell point, that would be ideal. If you find it hard to actually sell when the time comes though, you should set stop orders at your sell point right after you purchase the stock to make sure you actually execute if the stock drops. This is also helpful if you’re a long term investor that only checks your stocks once a quarter, since you can purchase the stock, set your stop, and forget about it until you get an email notifying you that your sell order executed. In this case, you might decide to give a thoroughly researched stock a significant amount of play below the actual support level.

The final reason to set your sell point at the time of purchase is to have a predetermined risk. If you have a set cutoff point going into the trade, you’ll be able to do a risk/reward analysis, which will help you determine if it’s a worthwhile endeavor. You’ll start to see why buying stocks that aren’t at pivots are bad ideas, but that’s a whole different topic for another post. For now, remember to cut your losses off at an objective point and don’t worry about your correct:incorrect pick ratio, only care about your total percentage profit.

Comments

One Response to “Cutting Your Losses”

  1. Lam Doan on October 23rd, 2007 10:45 am

    “I know people who’ve watched stocks lose 98% of their value because every time it dropped, they kept thinking it was the bottom” You weren’t talking about ME, were you?!?! Hahaha. Good stuff man.