Stock Trading 101: When to Cut Your Losses

stock market loss

There’s no worse feeling than selling a stock after it’s lost money – except when you hold on far past when you should have sold, as the stock drops more and more, making you question every trading decision you make from then on. Warren Buffet famously has just two rules he lives by – Rule #1: Never lose money. Rule #2: Never forget rule #1. After all, the whole purpose of investing is to end up with more money. If you’re just looking to preserve wealth, you might as well open up a savings account and forget about it.

But no matter how much research and due diligence you do on a stock, odds are that eventually you’ll find yourself invested in a loser. You might hold on at first, believing it’s simply a minor correction or mild profit-taking activity, but once a stock has lost 20 percent or more, panic starts to creep in. Knowing when to buy a stock is important, but knowing when to sell is just as critical in order to be successful in the markets.

Knowing when to let go

It’s one of the hardest lessons investors need to learn – when to sell a stock that’s lost money. Many traders attempt to recover from losses by chasing after it with more money. They convince themselves that the stock is cheaper now and more money being thrown at it will help mitigate the loss and bring down the break-even point.

There’s a certain logic to investing more in a loser. After all, if a stock drops 10 percent, you’ll need an 11.11 percent gain to break even. A 20 percent loss means you’ll need a rise of 25 percent to break even. But if you invested more once the stock drops in value, the gain doesn’t have to be so large to break-even on an investment.

The problem isn’t that it takes more of a gain to recover from a loss, though, it’s a refusal to accept the fact that a stock might just be a bad choice period. There’s nothing to say that a losing stock will recover. In some cases, a falling price might actually be a buying opportunity, but more often than not, a steady decline in value is a sign of something going wrong in the company.

The key to knowing whether to keep a loser or sell it comes from answering one question – have the reasons you bought the stock for changed? For example, if you bought a stock because it does business in China, but later spins off that segment, your reason for holding the stock no longer applies. However, macroeconomic conditions like a general correction due to poor GDP data don’t have anything to do with a single stock, so your reasons for owning the stock won’t change.

There’s a silver lining to selling a stock at a loss – you can take advantage of a strategy known as tax loss harvesting. The IRS allows you to offset up to $3000 in capital losses annually against your income and carry forward the excess into future tax years. You can use losses to offset gains so your tax liability won’t be as high. While it might not be an ideal strategy for long term success in the markets, it does help mitigate losses when they do occur.