How to Recover When an Investment Goes Bad

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If you follow sports, you've surely seen the replay by now: During yesterday's game against Kansas City, Patriots quarterback Tom Brady got hit low as he threw a pass, and went down screaming and clutching his knee.

For the Patriots, that was a huge calamity; Brady was arguably the key to their entire recent run of success, and he may be out for the whole season. At the same time, injuries are part of football, and the team, like all good teams, had a plan -- and a show-must-go-on mind-set. Brady's understudy stepped right in, got things rolling, and the Patriots won the game. It wasn't pretty, but it was a success.

Likewise, when your portfolio takes a hard hit, understanding how to respond is very important. Even if you manage to escape Brady-level damage throughout your entire investing career, you're going to have bumps and bruises along the way. Knowing what to do after the hit (I'm almost done with this metaphor, I promise) is the difference between an embarrassing loss and a successful day on the field.

No portfolio is immune from losses
If you don't think your portfolio is at risk for a big hit, think again. No matter how safe you think your stocks are, there's something that could hurt them. That's OK -- on average, over time, taking some risks works out pretty well -- but it's important to understand that risk is, well, risky.

It's one thing to hear about risk. But it's another thing entirely to open a quarterly statement and find out that 15% of your money is just gone. Or that a stock that seemed like a great long-term bet -- just as Washington Mutual (NYSE: WM) did not so long ago -- is down 90% and in deep, chronic trouble. Or that a golden gem like Basin Water (Nasdaq: BWTR) or ArthroCare (Nasdaq: ARTC) turned out to be a gold-plated pile of trouble.

It doesn't even have to be a huge structural disaster or a scandal to be worrisome. Two stocks I owned, NutriSystem (Nasdaq: NTRI) and Irwin Financial (NYSE: IFC), seemed like good investments at one time, but they've lost a ton of value in the past 12 or 18 months. Full disclosure: I lost money on both. That hurt.

But I recovered -- and here's how you can recover, too.

Recovering gracefully
Keeping one (or two or three) tough losses from leading you to portfolio-ruining (or retirement-ruining) mistakes isn't hard. It's mostly a matter of being informed, being disciplined, and taking a long-term view.

• Keep your perspective. Even the greatest investors have investments that go bad from time to time. That's why we diversify. On average, over the long term, we should be able to net 10% a year or more, but not all of your stocks will earn 10%. You'll have hot stocks like Activision Blizzard (Nasdaq: ATVI) and losers like Las Vegas Sands (NYSE: LVS) working together to come up with that average.
• Don't hold onto a stock without good reason. Behavioral finance researchers know that people often mentally anchor on a specific price -- often their purchase price, or an optimistic analyst's target -- and resist selling until the stock gets back to that price. But if your reason for holding the stock is no longer valid, you should strongly consider selling, no matter what you paid for it.
• Don't get discouraged; learn instead. Especially if you're new to investing, it's easy to get shaken by your first big loss. This is natural -- research has shown that people feel losses much more than they feel gains. But instead of wallowing in discouragement, take a long-term view: What can you learn from this loss that will make you a better investor?

That last point is the most important: Keep working on being a better investor. Choose stocks carefully and dispassionately, and don't be afraid to consider a mutual fund when a pro's touch might make more sense for a particular sector or asset class.

And practice good asset allocation. Research has shown that the decision to buy a certain type of stock -- large-cap value, small-cap growth -- can often have more impact on your portfolio's returns than the specific choice of stock. If you'd like to improve your portfolio's allocation, check out the July 2008 issue of the Fool's Rule Your Retirement newsletter. You'll find a complete retirement asset allocation road map in there, including an easy-to-use guide to get your portfolio to the next level. It's a paid service, but a free trial gets you full access for 30 days, with no obligation.