It's happened to everyone -- an investment you had so much confidence in lets you down and suffers a severe drop. What should you do?

If you're not prepared in advance for the possibility that any of your investments can suffer a catastrophic loss, then the first reaction you're likely to have will be to panic. Yet as you can imagine, that's usually the worst thing you can do.

Why you want to sell
Suffering a big loss with an investment is like taking a punch to the gut. It's often the last thing you expect to happen, and it hurts so much that you'd do almost anything to make the pain it causes go away.

In fact, that's why your first impulse is to panic-sell a losing investment. If you keep that loser in your portfolio, then you have to look at it day in and day out. Just seeing it among your holdings is a constant reminder of the huge mistake you made. In contrast, once you pull the trigger and sell, you don't have to think about it anymore -- you can just put the whole experience behind you.

Not just stocks
Of course, this sort of thing happens with stocks nearly every day. Bad news constantly throws various companies for a loop, and because information moves so quickly, it's easier than ever for panicking investors to push a stock's price down at lightning speed. Just in the past week, stocks like FactSet Research System (NYSE:FDS), Oshkosh, and Palm (NASDAQ:PALM) have suffered single-day drops of 10% or more resulting from bad news.

But don't trick yourself into thinking that your other investments aren't prone to exactly the same behavior. For instance, if you bought gold above $1,200 an ounce just a couple of weeks ago, either in bullion form or through an ETF like SPDR Gold Trust (NYSE:GLD), you've already suffered almost a 10% drop. Similarly, news of bankruptcy or other financial troubles can send a company's bonds running for cover -- and even Treasury bonds are prone to wild fluctuations during times of financial stress.

The cost of panic
Depending on what happens next, panicking can seem like a really smart move. Just imagine how happy those who sold during the early stages of 2008's bear market felt as they watched stock prices fall ever lower.

The problem, though, is that when your investment recovers -- and it usually does, eventually -- you often end up missing out on even more substantial future profits. For instance, say you took advantage of the low point in November 2008 to buy some of these beaten-down stocks:

Stock

Return, 11/20/08 to 3/9/09

Return, 11/20/08 to 12/18/09

Microsoft (NASDAQ:MSFT)

(13%)

77.3%

Hewlett-Packard (NYSE:HPQ)

(19.4%)

63%

3M (NYSE:MMM)

(25.1%)

47.4%

Source: Capital IQ, a division of Standard and Poor's.

As you can see, by March, you were sitting on some pretty substantial losses. Yet if you had panic-sold at that point, you not only would have made those losses permanent, but you also would have sold your chance at the impressive gains that followed.

The right move
Sometimes, selling after bad news is the right move. But rather than having a knee-jerk reaction, consider following these simple steps:

  • Know your rationale. For every investment you make, you should have a reason you think it will be successful. That way, when an alarming piece of news comes out, you can judge whether it's truly bad for the company or whether shareholders are overreacting and perhaps creating a better buying opportunity.
  • Get the whole story. Unfortunately, even unsubstantiated rumors can move a stock. Just consider the mistake last year, when an old story about United Airlines (NASDAQ:UAUA) and its 2002 bankruptcy filing was mistakenly rerun as breaking news. Those who dump shares without checking their facts can get two nasty surprises in a row.
  • Consider the alternatives. Sometimes, lots of investments drop at the same time. When that happens, it may make little sense to sell a declining investment if you're just planning to replace it with a similar one. Conversely, if you have a more compelling investment idea ready and available, then you should feel more comfortable selling.

It's never fun to see your investments take a big hit. But if you follow these simple steps, you can keep yourself from making an even bigger mistake.

Looking for the right investment to ring in the New Year? Tim Hanson can point you to the top markets right now.

Fool contributor Dan Caplinger wishes he'd bought more cheap stocks, but at least he didn't panic. He doesn't own shares of the companies mentioned in this article. The Fool owns shares of FactSet Research Systems, which is a Motley Fool Rule Breakers pick. 3M and Microsoft are Motley Fool Inside Value selections. Motley Fool Options has recommended a diagonal call strategy on Microsoft. Try any of our Foolish newsletter services free for 30 days. The Fool's disclosure policy never gets carsick, seasick, or market-sick.