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When you invest in stock market, it’s certain that you will have winning stocks as well as losing stocks. Even Warren Buffett is not right every single time. So the question becomes, when should you sell your losing stocks before it starts to cause serious damage to your investment account?
Why People Hold Onto Losing Stocks?
First, let’s look at why people like to hold onto their losing stock positions.
If you have invested in stock market and had a losing stock position before, did you ever tell yourself that you would immediately sell the stock after the price comes back to your break-even price?
But the longer you waited for it to happen, the lower the stock price fell and the more money you lost.
So, why is it so difficult to just cut loss?
This has a lot to do with how our brain is wired.
When it comes to pain and pleasure, we will do more to avoid pain than we will do to gain pleasure.
So, when we are faced with a losing stock, we will convince ourselves that it’s just paper loss and the stock will eventually bounce back.
We do it to avoid PAIN of losing money.
But the truth is that realized loss or not, it is still a loss.
Hoping and praying for it to bounce back will not help us.
Ignoring it does not make it go away.
What we should do is that we don’t let our emotions cloud our judgement and affect our decisions.
The Importance of Knowing When To Sell Your Losing Stocks
So, how important is it to know when to sell your losing stocks?
Let’s look at one example.
Billionaire hedge fund investor Bill Ackman and his investors took about a $4 billion loss on Valeant Pharmaceuticals International(VRX) after its share price dropped from all time high of $ 262 to around $10.
When the stock price fell more than 50% within a few month, he didn’t cut his losses but chose to add on to his losing position.
Because of this, he suffered a much bigger loss than before.
So, it’s vitally important to know when to cut your losing position before it causes serious damage to your account.
When To Sell Your Losing Stocks
Then, when should you sell your losing stocks before it’s too late?
First, ask yourself whether the reason for investing in the stock in the first place still stands.
For example, your reason for investing in the stock could be that it’s a good business and the stock is undervalued.
If the company’s fundamentals have changed substantially in a negative way, then you should sell away your stocks and cut your loss as soon as possible.
For example, the company’s earnings have deteriorated significantly.
And the big drop in earnings is not caused by a one-off event.
So, that could mean that lower future earnings are to be expected.
If this is the case, your reason for investing in the stock is no longer there.
When this happens, cut your losing stocks as soon as possible.
However, if there is little change in the company’s fundamentals, then the price drop could be just temporary.
If this is the case, here’s what you do next.
You find out the percentage loss of your losing stock position.
Is it a 10% loss?
Generally, you can tolerate a 10% to 15% fluctuation of the stock price on the downside.
But, you should have a hard percentage stop-loss for your stock.
The higher the percentage loss, the more difficult it is to bounce back to its break-even price.
Even if it goes back to break-even price, it could take a very long time.
So, having your money tied up in a losing position also have its opportunity cost.
Because you can take back your money and re-invest it somewhere else where it can generate better returns.
Lastly, there is tax considerations.
If it’s close to your tax filing date, you can consider selling your losing stock positions for tax purposes.
You can use your realized capital loss to offset your income on your tax returns.
As different countries have different tax laws, you should check the maximum amount they allow you to use to reduce your tax.
How To Prevent Yourself From Selling Your Losing Stocks Too Late
Here’s a simple answer.
You should always have a pre-determined stop-loss for your stocks.
Why is it a pre-determined stop-loss?
Because it can stop you from making costly emotional investment decisions.
When you plan your stop-loss and take-profit beforehand, you don’t have any emotional attachment to your stock positions and your judgement is objective.
Once you have bought the stocks, you just need to stick to your plan.