In the battle for investment survival, you can learn a lot from judo. The first and most important lesson in that martial art is the same for the stock market: damage control.
Judo masters begin not by learning how to throw, but how to fall. They practice this skill until it is as natural as breathing. No matter how many times they are flipped, they can rise to fight again.
Highly successful stock pickers go through similar training: They must learn how to cut their losses short. This means selling a stock when it is down 7% or 8% from your purchase price.
Sounds simple, but many investors have learned the hard way how difficult it is to master the most important rule in investing.
No one wants to sell for a loss. It is an admission that you made a mistake. But if you can set your ego aside, you can take a small loss and still be fit enough, both financially and mentally, to invest the next day. Cutting losses quickly prevents you from suffering a devastating fall that is too steep to recover from.
Consider the math. Say you buy a stock at 500. For whatever reason, it drops 8% to 460 during the next few days. You promptly unload it and move on. To reclaim that loss, you need to make an 8.7% gain on your next purchase with your remaining capital, which should not be hard to do.
What if you hold on?
You are sure the stock will snap back. Your research convinces you it is worth Rs 1,000, so why get scared by a minor setback?
There is one problem. The market does not care who you are, what you think or how much you believe in a stock. It says you miscalculated, at least in the short term — a message that gets louder as the stock drops 25% to 375. To get back even, now you need a 33% gain, which is much tougher to come by than that easy 8.7%.
What if the market really does not like your stock and slices it in half to 250? You don’t need a calculator for this one: To recover a 50% loss requires a 100% gain. How many stocks did you pick last year that doubled in price?
If you limit losses on initial purchases to 7% or 8%, you can stay out of trouble, even if only 1 out of 4 buys delivers a modest profit of 25% or 30%. You can be wrong 3 out of every 4 times and still live to invest another day.
Let’s take the example of Sachin Tendulkar, one of the best batsmen of all times. Sachin scored more runs than his Test batting average of 53.78 in only 110 innings out of 329 played for India. That means he scored below average for 2 out of 3 times. Yet, he ended being the most successful run getter in Tests.
The same is true for successful investors. They calmly take a small loss when they are wrong and make it big when they find the next potential winner.
So leave your emotions behind. Cutting losses with discipline will help keep your head clear when it is time to return to the market. A great paradox of investing is that the ripest buying opportunities occur just after bear markets — when the major stock averages have declined 20% or more.
That’s exactly when most investors who haven’t cut their losses are reeling and don’t want to be hit again. It is hard to think straight after losing thousands and lakhs of rupees. But the market always recovers. What kind of shape will you be in?
Here’s an example of a stock that gave a failed breakout recently, forcing us to cut our position in it.
Thirumalai Chemicals was added to our portfolio after it broke out of a first-stage base pattern on April 23, 2018 (1). However, it failed to trend higher and within six sessions the stock was down more than 8% from our add price. We removed the stock after looking at its technical weakness and below-expected Q4 numbers on May 3, 2018 (2). Since then the stock has corrected by an additional 20% and is now languishing below its 50-day and 200-day lines (3). Thanks to our sell rules, we did not let emotions take over and got out of the stock much earlier.
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