“CUT YOUR LOSERS and let your winners run.”
It’s a trading rule as old as the market itself. But while amateurs and pros alike are familiar with the saying, few have thought about the logic behind it. A few weeks ago we talked about the importance of letting your winners run. This time, we’ll focus on the first and more difficult half of the formula: taking losses.
The human mind is a powerfully manipulative beast, and the biggest problem most people have is that their inner beast interprets losing trades in exactly the wrong fashion. Simply put, we ignore the reality of losses while simultaneously counting our winning chickens before they’re hatched. Within our portfolios, we too often treat a paper loss as a temporary phenomenon, while a paper gain is wrongly seen as money in the bank. This is a logical fallacy to which almost all of us fall pray. But the truth is, a gain is only a gain once you’ve taken it, while a loss is a loss whether it’s realized or on paper.
The stock market, like many areas of our lives, moves in trends. Weak stocks tend to get weaker or, at least, stay weak. If you’re in the enviable position of being able to take a risk, with more than 10,000 publicly traded securities out there, why opt for an already losing trade? As we pointed out over the past few months, there’s always a bull market somewhere — even if it’s not in Microsoft (MSFT), Merck (MRK) or the washed up names of the Standard & Poor’s 500. When a stock is declining, it’s telling you something — don’t buy me. (more…)