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The Art Of Cutting Your Losses
by Ken Hawkins

One of the most enduring sayings on Wall Street is "cut your losses short and let your winners run". Sage advice, but many investors still appear to do the opposite, selling stocks after a small gain only to watch them head higher, or holding a stock with a small loss, only to see it worsen.

No one will deliberately buy a stock they believe will go down in price and be worth less than what you paid for it. However, buying stocks that drop in value is inherent to the nature of investing. The objective, therefore, is not to avoid losses, but to minimize the losses. Realizing a capital loss before it gets out of hand separates successful investors from the rest. In this article we'll help you stand out from the crowd and show you how to identify when you should make your move.

Reasons Investors Hold Stocks With Large Unrealized Losses
In spite of the logic for cutting losses short, many small investors are still left holding the proverbial bag. They inevitably end up with a number of stock positions with large unrealized capital losses. At best, it's "dead" money; at worst, it drops further in value and never recovers. Typically, investors believe that the reason they have so many large, unrealized losses is because they bought the stock at the wrong time or it was a matter of bad luck. Rarely do they believe it is because of their own behavioral biases.

Let's take a look at a few of these biases:

Stocks always bounce back - don't they?
A glance at a long-term chart of any major stock index will see a line that moves from the lower left hand corner, to the upper right. The stock market over any long period of time will always make new highs. Knowing that the stock market will go higher, investors mistakenly assume that their stocks will eventually bounce back. However, a stock index is made up of successful companies. It is an index of winners. Those less successful stocks may have been part of index at one time, but if they've dropped significantly in value, they will eventually be replaced by more successful companies. The indexes are always being replenished by dropping the losers and replacing them with winners. Looking at the major indexes tends to overstate the resiliency of the average stock, which does not necessarily bounce back. In fact, many companies never regain their past highs and some go bankrupt. (To learn more about this, see Limiting Losses.)

Investors do not like admitting they've made a mistake.
By avoiding selling a stock at a loss, many investors do not have admit to themselves that they've made an error in judgment. Under the false illusion that it is not a loss until the stock is sold, they elect to continue to hold a losing position. In doing so, they avoid the regret of a bad choice. 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 paper loss. This means they will break even, and "erase" their mistake. Unfortunately many of these same stocks will continue to slide.

When stock portfolios are doing well, investors often tend them like well-maintained gardens. They show great interest in managing their investments and harvesting the fruits of their labor. However, when their stocks are holding steady or are dropping in value, especially for long periods of time, many investors lose interest. As a result, these well-maintained stock portfolios start showing signs of neglect. Rather than weeding out the losers, many investors do nothing at all. Inertia takes over and, instead of pruning their losses, they often let them grow out of control.

Hope Springs Eternal
Hope is the belief in the possibility of a positive outcome, even though there is some evidence to the contrary. Hope is also one of the primary theological virtues in various religious traditions. Although hope has its place in theology, it does not belong in the cold hard reality of the stock market. In spite of continuing bad news, investors will steadfastly hold onto their losing stocks, based only on the faint hope that they will at least return to the purchase price. The decision to hold is not based on rational analysis or a well-thought out strategy and unfortunately, wishing and hoping that a stock goes up does not make it happen.

Realizing Capital Losses
Often you just have to bite the bullet and sell your stock at a loss before those losses get bigger. The first thing to understand is that hope is not a strategy. An investor has to have a logical reason to hold a losing position. The second point is, 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 the stock's future prospects.

Let's look at a few ways of assuring a small loss does not become "dead" money or turn into a much larger loss.

Have an investment strategy.
Having a written investment strategy with a set of rules both for buying stock and selling stocks will provide the discipline to sell stocks before the losses blossom. The strategy could be based on fundamental, technical or quantitative factors. (For more insight, read Tailoring Your Investment Plan and Having A Plan: The Basis Of Success.)

Have reasons to sell a stock.
An investor generally has quite a few reasons why he or she bought a stock, but typically no set boundaries for when to sell it. Don't let this happen to you. Set reasons to sell stocks, and sell them when these things occur. The reason could be as simple as: "Sell if bad news is released about corporate developments or a price target".

Set stop losses.
Having a stop-loss order on shares that you own, particularly the more volatile stocks, has been a mainstay of advice on this subject. The stop-loss order prevents your emotions from taking over, and will limit your losses. (For more on how this can help, read The Stop-Loss Order - Make Sure You Use It.)

Would you buy the stock now?
On a regular basis, review every stock you hold and ask yourself the simple question: "If I did not own this stock, would I buy it today?" If the answer is a resounding "No", then it should be sold.

Tax-Loss Harvesting Strategies
A tax-loss harvesting strategy is used to realize capital losses on a regular basis and provides some discipline against holding losing stocks for extended periods of time. to put your stock sales in a more positive light, remember that you receive tax credits that can be used to offset taxes your capital gains. (To learn more about tax credits, see Give Your Taxes Some Credit.)

Taking corrective action before your losses worsen is always a good strategy. In investing, avoiding losses entirely may not be possible; successful investors accept this and try to minimize their losses rather than avoid them. Selling a stock at a loss and receiving a tax credit is one benefit you will receive. Selling these "dogs" has another advantage too - you will not be reminded of your past mistake every time you look at your investment statement.