Learning Article : Cutting Losses Is like Buying an Insurance Policy

The policy of limiting losses in stock market is similar to paying insurance premiums. You reduce your risk to exactly the amount you are willing to take. Granted, many times the stock you sell will immediately turn around and go up. You will probably get very agitated and think you made the wrong decision if that does happen.

Let’s say you bought insurance on your car last year and didn’t have an accident. Does that mean you wasted your money? Are you going to buy the same insurance this year? Of course you are! You buy insurance just in case – to protect you from the remote possibility of a serious loss.

It is the same for the winning investor who cuts losses quickly and closely; he/she wants to protect against the possible chance of a larger potentially devastating loss from which it may not be possible to recover. Some people have even damaged their health agonizing over declining stocks they were holding. In this situation, it is best to sell and stop worrying.

If a person bought XYZ stock last year at Rs 400 and it drops to Rs 300, he/she may think to buy it more and average the price down. Now, when it drops to Rs 200, he/she may add again. And finally, when it drops to Rs 75, that person might be out of market after incurring huge loss. So, never argue with the market.

“When you make a mistake in the stock market, the only sound thing to do is correct it. Don’t fight it.  – William J. O’Neil

Small losses are cheap insurance and the only kind of protection you can buy on your investments. Even if a number of the stocks move up after you sell, which many of them surely will, you have accomplished your critical objective of keeping all your losses small. And you still have your money to try again for a winner in another stock.

What do you think? Please email us any questions or comments.

Disclaimer: Information contained herein is not and should not be construed as an offer, solicitation, or recommendation to buy or sell securities. It is for educational purposes only.

Performance computations reflect a time-weighted rate of return and includes a brokerage of 0.5%. All holdings are rebalanced to equal rupee amounts daily. Dividends are not considered in computations. Percent gains and losses are calculated for all issues that remain on the “Current Holdings” at the end of the day. For stocks that were added to “Current Holdings”, the basis used to calculate the percent change is the price noted when the issue appeared as a “Current Holdings” in MarketSmith India. For stocks that were removed, the selling price used to calculate the percent is the price note d when the issue appeared as “Removed” in the MarketSmith India. For more information, see our Legal disclosures here.

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