Make Room for the Best Stocks

Unless you're the savviest investor on the planet, you've probably seen some substantial losses in your stock portfolio over the past year and a half. But even though panicking when your investments tank won't help you get back on track, you shouldn't hesitate to sell shares, even at a loss, if it's for the right reason.

Many investors irrationally avoid selling shares for less than they paid for them. They wait rather than pulling the trigger on a stock sale, hoping that falling stocks will recover back to their break-even point so that they can avoid "locking in" a loss. And even with shares that have fallen 70%, 80%, or even more -- shares that have little or no chance of recovering their former glory anytime soon -- stubborn investors hold out to at least reduce those losses somewhat.

But by doing that, you can miss out on some of the best stocks in the market.

A brand-new day
You don't have to work hard to understand why people hang onto their losers. No one likes to admit making a dumb move, and as long as you hold on, a rebound might prevent you from having to face the fact that you made a mistake.

The problem, though, is that your purchase price really has nothing to do with how your shares will perform anytime in the future. It doesn't necessarily reflect the company's true value when you bought them, nor does it give you any guarantee that the stock will eventually trade again at that level. It just happens to be the price you paid -- nothing more.

Now, the right way to think about your investments makes a lot more sense than focusing on the number on your trade ticket:

• You should own only the stocks in which you have the most confidence. If a stock falls for a reason that changes your mind about its prospects, you should get rid of it.
• Also, if you discover another great stock that you don't own, you'll have two choices: Either find enough savings to add it to your portfolio, or sell a stock you currently own and use the proceeds to invest. Stocks that have disappointed you are great candidates to raise cash.

It's that simple. Of course, there are other considerations -- such as taxes on capital gains -- that can influence your decision-making. But in a nutshell, if a stock you own isn't one of your best prospects to make money, then you owe it to yourself to replace it with another stock that is.

Saddling yourself with losers
To illustrate this point, let's look at an example. Say you started investing in 2007 and decided to put some of your money into financial stocks. Within 12 months, you would've seen significant losses:

Source: Yahoo! Finance.

Now say that you considered two strategies. You could have concluded that financial stocks were down for the count, and replaced them with a portfolio of stronger, recession-resistant companies. Or you could have stuck with the financials and hoped for a recovery.

Granted, it would've hurt to take big losses by selling your shares this time last year. But as we know well by now, diversifying in nearly any direction away from financials would've been a better bet. Consider:

Source: Yahoo! Finance.

It all boils down to this: Whether you've earned a profit or lost money on a stock, it's only worth holding onto if you believe it will do well in the future. Although unexpected losses can be a short-term phenomenon that reverses itself when better times come, they can also indicate that you missed some important factor in doing your stock research.

With thousands of publicly traded stocks, there are always plenty of alternatives to any stock that doesn't pass muster with your investing standards. Don't hesitate to pull the plug, even if it means realizing a loss. The gains you reap from better stocks will make up for your losses.

For more on investing better, read about:

• Warren Buffett's biggest mistake.
• Companies you should be buying right now.
• How to make millions from thousands.