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Warren Buffett once said that the most important rule in investing is never to lose money. What he didn't say -- but perhaps would have, if he'd thought of it -- is that if you dump every stock at the first sign of trouble, then you'll end up throwing a lot of babies out with the bathwater.
Last plane out
The mood of the financial markets has changed markedly since the beginning of the year. After a year's worth of impressive gains, stocks have started moving up and down more wildly. That's putting some investors on edge, as they're torn by a familiar dilemma: Do you get out now and lock in those gains? Or do you stay invested in the hopes of even bigger profits down the road -- but potentially risk a big market drop if you don't get out in time?
Obviously, this isn't the first time that investors have had to address this question. Although selling out at the first sign of trouble often appears prescient when a total collapse actually occurs, you simply can't ignore the times when early-warning systems cry wolf too often -- getting you out of big opportunities at what later proves to be exactly the wrong time.
Avoiding the worst
There are a couple of different ways that investors set up defenses to minimize losses. Some use stop-loss orders at a predetermined price point -- say, 10% below where they purchased their stock, as an example. If something happens to drive the shares below that point, your broker will automatically sell your shares, limiting your losses to around that 10% figure.
The other method is simply to watch for bad news on the fundamentals front for the stocks you own. Even if share prices don't react negatively to particular news, you might nevertheless see it as harmful for the company and therefore want to take the opportunity to get out while the getting's good.
The obvious benefit of such systems is that they avoid the cataclysmic losses so many stocks have suffered throughout recent years. For investors in bankrupt companies from Enron to Chrysler to General Motors, such a strategy would have helped them avoid total capital annihilation. And if you'd gotten out of the stocks of some of the worst victims of the financial crisis -- companies like Morgan Stanley (NYSE: MS ) , Pulte Homes (NYSE: PHM ) , and Kimco Realty (NYSE: KIM ) -- just as the subprime mortgage problem was being discovered rather than waiting until the full extent of the problem made itself manifest years later, then you could have saved yourself a ton of money.
Missing the best
You'll definitely protect your portfolio if you observe the practice of limiting your losses. The problems usually come from what you do next. Consider the questions that loss-limiting raises:
- Are the stocks off-limits forever? If you can buy back a stock you've sold, then you might well get trapped anyway -- as many value investors did in evaluating Enron. If you categorically avoid reinvesting at lower prices, though, you'll miss bounceback candidates like priceline.com (Nasdaq: PCLN ) or Visa (NYSE: V ) , both of which have made back their losses.
- What's trouble? Sometimes, a problem is so obvious that you can't miss it. Toyota's (NYSE: TM ) recent safety issues or the lawsuits that plague tobacco companies like Altria (NYSE: MO ) provide good examples of problems that no investor could possibly miss or discount as unimportant. Yet sometimes, the small hints of oncoming trouble seem obvious only in hindsight. Depending on being able to find them in every case is a dangerous proposition.
- What's the limit? How big a loss is too big? Set the number too low, and even ordinary market fluctuations will often trigger sales. Set it too high, and you'll put more of your capital at risk than you'd like.
The concept behind limiting your losses is sound. Unfortunately, trying to distill that concept into a hard-and-fast rule that works for any stock can create even bigger problems.
When trouble hits your stock, don't ignore it. But don't panic-sell either. The best approach is to look closely at each situation individually, understanding the particular problems involved and realizing that not every problem is just the tip of a larger iceberg. For some stocks, now is the right time to sell -- but that won't always be the right answer.
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