First Rule Of Investing: Cutting Losses

Investor's Business Daily - investors.com

Before founding Investor’s Business Daily in 1984, Bill O’Neil already had 25 years of experience in the market as an individual investor, stockbroker, investment adviser and owner of a securities brokerage and research firm. His career started at age 22, just after he graduated from college, got married, joined the Air Force and became interested in his financial future. He bought his first stock with $500 — all he had at the time. He also started reading books on the market. According to O’Neil, the best was Gerald Loeb’s “Battle For Investment Survival.” It’s there we pick up our conversation.

Q: What is the single most important thing an investor should know?

O’Neil: Loeb was a highly successful investor and preached cutting all your losses short. And for me, this is Rule No. 1. You must always protect your investment account. Particularly if you invest on margin (use borrowed money), cutting losses is absolutely essential.

Whether you’re a new or experienced investor, the hardest lesson to learn is that you’re simply not going to be right all the time. And if you don’t cut every loss quickly, sooner or later you’ll suffer some very large losses. I’ve known seven highly intelligent, educated men in their 40s who were wiped out because they invested on margin and had no sell discipline. Brains, education, ego, stubbornness and pride are deadly substitutes for having and following sound selling rules.

The problem is, you always hope to make money when you buy a stock. And when you have to sell and take a loss, you find it gut-wrenching and hard to admit you were wrong. You’d rather wait and hope the price will come back.

To make matters worse, when you do cut losses, half the time the stock will turn around and go back up. Then you’re really upset. You conclude you were wrong for selling and that the loss-cutting is a bad policy.

How you think about losses is critical. Historically, this is where most investors go wrong and get confused.

Ask yourself the following: Did you buy fire insurance on your house last year? Did your house burn down? If it didn’t, were you upset because you wasted your money on the insurance? Will you refuse to buy fire insurance next year? Why do you buy fire insurance in the first place, because you know your home is going to burn down?

No! You buy insurance to protect yourself against the remote possibility you could suffer a major loss. That’s all you do when you cut short your losses.

Q: How do you define short?

O’Neil: For Loeb, it was 10%, which is probably a good rule for most beginning investors. But when you use charts to time your purchases more accurately, I recommend cutting all losses at 7% or 8% below your purchase price. By doing this, you’re taking out little insurance policies to protect yourself from possible substantial losses.

If you let a stock go down 50% from where you bought it, you must make 100% on the next stock just to break even. Now, how often do you buy stocks that double in price?

Q: How long did it take you to become successful at investing?

O’Neil: It took me two to three years to figure out how to put the whole system together. It doesn’t happen overnight. For most people the learning curve is about the same. As the years go by, you should get better and better at stock selection, and the number of individual 7% or 8% losses should drop. Plus, these small losses will be offset by much larger profits from your winners.

Think of a number of controlled losses as your tuition to Wall Street. Most people think that investing in a college degree is a sound decision. They don’t think of it as a waste of money because they have hopes of having that degree pay off in future success. Why should success in the stock market be any different?

Anything worth succeeding at takes time to learn. Professional ballplayers aren’t made in three months, and neither are successful investors. The only difference between the successful person and everyone else is determination and persistence.

Q: How persistent have you had to be at times?

O’Neil: I once had a string of 10 stocks that I cut losses on. But the very next one emerged just as the market came out of a correction (downtrend) and more than tripled in price. I’ve often thought: “What would have happened if I had gotten discouraged and quit because the previous 10 stocks didn’t work?”

The tricky part is getting rid of the emotion attached to making decisions, like cutting losses. It doesn’t feel comfortable to sell something you may have purchased only a few weeks ago because it’s now down 8% below your cost. Emotions take over. We try to defend our original decision to buy and justify holding the stock.

But you can’t go through life looking in the rear-view mirror. You can get yourself in a lot of trouble with the “could’ves,” “would’ves” and “should’ves.”

When you bought the stock, that was last week or last month — not today. Today is a whole different situation, and you’ve got to protect yourself from serious losses — which could happen to anyone — so you can still invest tomorrow.

Q: Why did you pick 8% as the rule?

O’Neil: If you cut your losses at 8%, it will always allow you to survive to invest another day. I’ve seen people go bankrupt or ruin their health because they’d fallen in love with a stock, couldn’t face up to and admit mistakes, and couldn’t make the hard sell decisions. Vacillating when it comes time to sell is how you will sooner or later experience big losses. And big losses will cause you to lose your confidence, which you absolutely cannot let happen if you expect to continue investing.

If you’re worried, the old adage, “Sell down to the sleeping point,” is the best way to relieve some pressure. You don’t have to sell it all, just sell something so you can sleep.

If you cut all your losses at 7% or 8% below your purchase price, and then sell just a few of your stocks when you’re up 25% to 30%, you can be right once and wrong twice and still not get into trouble.

Your best-performing stocks should be held longer for a larger possible profit. Always sell your worst-performing stock first, not your best-performing stock.