Why These Big Winners Are Really Losers

Eight months into the stock market's recovery, many stocks have posted some truly phenomenal gains. But for long-term investors, even those huge gains won't be enough to make up for the losses they suffered on the way down. Smart investors should take that into consideration before they throw caution to the wind in hopes of profiting from the next bull market.

Getting back to bullish
With the S&P 500 having risen over 60% from its March lows, it's easy to understand why people are feeling good about the stock market again. Just as the 1987 stock market crash became a faint memory after just a few years when the market had fully recovered, so too are investors forgetting the full brunt of last year's financial crisis. Given how well some highly speculative stocks have performed so far this year, it seems ridiculous to think about protecting your portfolio with defensive stocks right now.

The funny thing, though, is that if you were a long-term investor in most of those speculative stocks, you would've been better off leaving them alone in the first place. Staying on the sidelines and earning next to nothing in a bank account would still have left you ahead -- even after you add in the multibagger gains some of these stocks have seen since March.

The secret of gains and losses
Especially during bull markets, investors tend to forget the importance of preserving capital. Missing out on big gains seems like the worst thing that could ever happen to you, and if you're not careful, it's easy to lose perspective and take on more risk than you should chasing after high-performing stocks.

The problem, though, is that even incredibly strong returns can't necessarily overcome the big losses you'll suffer if you invest in the wrong stocks during bear markets. As an example, just take a look at some of these well-known stocks and how they've done both recently and over the past couple of years.

Source: Yahoo! Finance.

As you can see, these stocks have knocked investors' socks off during the rally. But they fell so much in the lead-up to the financial crisis that even with those phenomenal gains, they're still trading well below their 2007 levels. And although the overall market has obviously also lost ground in the past two years, all but one those seven stocks lag the total return of the S&P 500 index as well.

Learn your lesson
The key, therefore, is remembering the dire consequences of big losses even during rosy times. It might well be worth it to give up some gains during bull markets if by doing so, you reduce the chances of suffering an irretrievable loss when the financial markets go sour.

How do you do that? Here are a few ideas:

• Diversify. While stocks, real estate, and commodities were tanking last year, many bonds soared. Those who mixed their stocks with bond exposure greatly reduced their losses.
• Set stop losses. Sometimes, you simply make a mistake in choosing a particular stock. If you decide in advance that there's a maximum amount you're willing to lose, you can prevent yourself from getting into such a big hole that you'll never recover. The downside to this, though, is that depending on where you set your stop loss, you'll also sometimes sell just before a stock hits bottom.
• Know your risk tolerance. If you can't handle a big loss, avoid speculative stocks in favor of well-established companies. You may not have the same potential for gains, but the losses you avoid should make up for the less impressive gains.

During an advance like the current rally, it's easy to lose sight of how damaging big bear markets can be. But by being ever vigilant to prevent crippling losses, you'll ensure better long-term results for your portfolio.

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