You don't have to make it back the way you lost it. -- Warren Buffett 

That simple sentence from superinvestor Warren Buffett is more profound than you might think. It offers an insight that eluded me for many years, costing me money in the process. Here's a look at how you might apply it to your own financial decision-making.

First, though, in case you've heard the name Warren Buffett but are not sure just why you might want to listen to what he has to say, know this: He has increased his company's (Berkshire Hathaway) value by an average of nearly 20% per year over 57 years. The S&P 500, also no slouch, averaged 10% annual gains during the same period.

Warren Buffett is shown, from the shoulders up.

Image source: The Motley Fool.

Dealing with losses

Buffett's quotation addresses what we might do when we lose money. Let's apply that to stock investing. Imagine that you've bought shares of stock in a company and you're down, say, 50%. That will sting, of course. What should you do about it? Well, here are some options:

  • You might sell in disgust.
  • You might buy more because the stock seems cheaper now.
  • You might hang on, hoping or waiting for the shares to rebound, so you can recoup your losses.

Plenty of people would sell their shares. If you no longer have confidence in the company and its growth prospects, selling is the right thing to do.

Buying more shares is risky, because the company may be facing intractable problems. Before buying any more of the stock, do some due diligence. Read up to see why the shares have fallen and assess whether any problems the company is facing are short-term or long-term ones. When in doubt, do not buy more shares.

Hanging on is a common move. Many investors will be upset that the stock has let them down, and will be waiting and/or hoping that the shares will start going up again, to wipe out their losses. This is often a very bad move -- especially if you no longer have much confidence in the company.

What Warren Buffett says

When you're hanging on to a losing stock, hoping it will go up in value, remember what Warren Buffett said: "You don't have to make it back the way you lost it."

It's always best to have your hard-earned dollars parked in your best investment ideas, and when you have lost faith in a company, it's no longer one of your best ideas. It can be hard to think of selling the shares and recognizing a fat loss, but look forward instead of backward. That money is gone. Whatever is left should be moved into one of your best investment ideas -- perhaps the stock in which you have the most confidence. After all, you're more likely to see that remaining money gain ground in your best idea than in the company that lost your confidence. You don't have to recoup your losses via the troubled company -- you can recoup the losses via one or more better, more promising companies. (This was a big epiphany for me, years ago.)

A silver lining -- for taxes

Note, too, by the way, that when you have a capital loss, such as from shares of stock you sold, you get to offset capital gains with it come tax time. So there's a bit of a silver lining that can come in handy. If, for example, you have lost $4,000 on a stinker and have $9,000 in taxable capital gains for the year, you can shrink those gains to $5,000, saving a bunch on taxes.

And if you have $4,000 in losses and only $3,000 in gains, you can wipe out the gains to $0 and apply $1,000 in losses to your ordinary income, shrinking it. You're allowed to shrink your income by up to $3,000 with losses. If your losses exceed even that, you can carry forward losses to the next tax year(s).

Don't make it back the way you lost it

Buffett's quotation can apply in other ways, too. There are, after all, lots of ways that we lose money. So if you've lost money by investing in some of your brother-in-law's failed business ideas, consider not continuing to invest with him, hoping that one of his ideas will hit the jackpot and wipe out your other losses. (Of course, if you really do believe in him and his ideas, ignore this advice.)

If you've lost a lot of money by investing on margin -- that is, with borrowed money -- it's not smart to keep doing so, hoping that some investment will be a big winner, paying off your growing debts. If you've lost money investing in penny stocks, which are notoriously risky, you'd do well to start investing in companies that have proven themselves profitable and well-managed.

Next time you find yourself staring at a loss, remember the savvy words of Warren Buffett.