Early in my investing career I decided that anyone who claims to be right in the stock market 100% of the time is a liar, and anyone who believes him is a fool.
Everyone takes losses in their portfolio. The beauty of the stock market is that you only have to be right 60% to 75% of the time (hardly anyone can sustain an 80% success rate) to make good money, provided you deal with your losses the right way.
Look yourself in the mirror
The first step to effective loss management is to look your losers square in the eye. Too many investors shove their losers away in some dark, dusty corner of their portfolio and shudder at the mere mention of red ink in their account. Drag those losers out into the cold, cruel light of day and let them teach you something about your investing mistakes.
I use two methods to review my portfolio losses, one weekly and one annual.
The weekly evaluation is part of a regular portfolio summary I started in September 1997. It has three key numbers: the total number of stock and options positions in the red, the percentage of my total portfolio the paper losses represent, and how much of my total portfolio assets are tied up in losing positions.
In a portfolio with about 80 positions, it looks like this:
"This week: 10 stocks/7 options in the red -- losses equal 1.6% of the portfolio; market value 9.85% of the portfolio. Last week: 10 stocks/9 options in the red -- losses equal 2% of the portfolio; market value 9.5% of the portfolio."
By comparing two weeks in a row, I see immediately if the portfolio's red ink has taken a sudden turn for the worse. Stocks and options are tracked separately because option positions are more volatile and subject to quick swings from profit to loss. The portfolio-percentage loss tells me how much more I would be up for the year if I had never bought those losers, and the final figure reminds me how much of the portfolio could be moved into more profitable stocks if I dumped the losers tomorrow.
Of course I don't just sell every stock or option position that goes underwater. Nobody should. For someone who likes buying unknown, unloved stocks, watching them wallow in obscurity and sometimes red ink is par for the course. But this way I know where I stand, and whether my red ink corner is staying within tolerable limits (which are: less than 20 to 25% of the stocks in the red, losses under 5%, and market value under 20%).
The second review is an annual affair where I set a minimum threshold for eligible losses, find every one in the previous year's trading records, and write them out by hand chronologically. The number of losses you have to dig out depends on how actively you trade or turn over your investment portfolio. This year, I chose 0.1% of the portfolio for the threshold. My goal is never to exceed 0.5% of the port in any single loss; happily only one reached that level, and most were under 0.2%.
The painful truth
For the year, my big losses equaled about 9% of my starting portfolio. So despite beating the indexes by double digits and then some, I could have done much better if I had never been wrong (which will happen when pigs sprout wings and fly). I definitely had too many losers over my threshold.
Next question -- were any of my losses really dumb, not based on a coherent investment rationale? No, I am glad to say. Looking at the largest 10 losers, I can go back and say here is why I went long or short; the answers fit my personal investing style.
But there was a definite theme to the boo-boo's: sector rotation.
Losses were few and far between in the first quarter. In the second quarter, I jumped on the bandwagon with some mining and transportation stocks that had glowed red hot for months, then fell into the abyss in the May sell-off. I joined the party too late in gold stocks Anglo-American
The second half of the year was a showcase in struggling longs in energy stocks like Pioneer Drilling
And the lesson is ...
Now is when a slick market scribe would whip out a handy dandy catch-all rule for buying and selling individual stocks based on sector momentum. I don't have one. Value investors frequently swim against the tide, buying the stocks that look cheap but no one else wants, or shorting market darlings that really don't deserve their multiples.
I paid the price in the second half with modest but noticeable losses in energy longs and homebuilder shorts. I would probably do the same thing again; but in 2007, I will stop and think twice before I take too many contrarian positions. That's what my losses from 2006 are telling me.
Didn't I learn how to avoid big losses in all the years before then? Sure, I learned to avoid sky-high P/E multiples because "it's different this time" (2000). I learned not to put too much money into options (2001). I learned not to bet big on one "sure thing" stock and vaporize a chunk of my portfolio when it went wrong (2002). I learned that momentum trumps valuation in short-term short squeezes (pick a year; I have trouble remembering that one).
The market is full of lessons for the investor. And I did a lot more right than wrong in 2006. This year, no doubt, I will learn a few more expensive lessons. But I will be out there looking for them among my losers, not lost in denial.
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Fool contributor Dale Baker, a private client portfolio manager and former U.S. diplomat, is a firm believer that you always win by not losing. He welcomes your questions or comments. The Motley Fool's disclosure policy is here.