One of the fundamental principles in investing is knowing when to cut your losses. If you find yourself desperately hoping for a failing trade to turn around, it's time to reassess your strategy. Hope alone is not a reliable approach.
When you own a stock that is consistently losing value, the prudent course of action is to sell it. Accept the loss and move on. Of course, it's essential to have some tolerance for minor setbacks—there's no need to panic and sell when the stock dips by a mere 1%. However, if it plunges by 20% or more, it's probably wise to consider selling.
There are several reasons behind this principle...
First, stocks tend to follow trends. If they are on an upward trajectory, they often continue to rise. Conversely, if they are in decline, they frequently keep falling.
The reality of the stock market is that turnarounds are rare. While it may be tempting to root for the underdog, it's crucial to remember that, when it comes to stocks, it's better to support the key players.
Second, holding on to a losing stock ties up both your financial and emotional capital. Your money becomes trapped in an unprofitable investment, and you spend considerable time checking your brokerage account, anxiously waiting for a potential recovery.
At Jared Dillian Money, one of my primary goals is to alleviate your financial stress. Selling underperforming stocks and seeking new opportunities will provide you with a sense of relief and enable you to focus on more promising investments.
Finally, human psychology tends to allow losses to snowball. Strangely enough, people are quick to take profits. If a stock skyrockets by 20%, they happily sell it to secure their gains, even though that might not be the wisest move (more on this shortly).
However, when individuals purchase a stock that subsequently drops by 20%, they often hold on to it, hoping for a rebound. Sadly, this mindset can lead to riding the stock down to its demise.
Do not fall into this trap. Surrendering and accepting defeat is the key to limiting losses and protecting your capital.
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Allowing your losing investments to persist is bad, but capping your winners is even worse. This approach is a surefire way to become an unsuccessful investor. As mentioned above, people tend to take profits eagerly. However, it's vital to remember that stocks generally exhibit upward trends over time.
To achieve substantial gains, you must learn to add to your winning positions. Admittedly, this can feel counterintuitive, but I encourage you to give it a try.
Start by purchasing a small stake in a stock, and if it appreciates, consider buying more. If the upward momentum continues, increase your position further and allow the stock to flourish.
This is the secret to successful investing: Do more of what works and less of what doesn't.
It's important to note that the guidance provided here does not apply to long-term investments, such as your 401(k), IRA, or other retirement accounts. Your retirement funds should be allocated to secure assets, such as The Awesome Portfolio, consisting of a diversified mix of stocks, bonds, cash, gold, and real estate.
For these accounts, you want to engage in a strategy called "dollar-cost averaging." This involves consistently buying assets regardless of market fluctuations. Dollar-cost averaging is considered the best approach for long-term investing.
Once you have allocated 90% of your funds to stable investments, like the ones laid out in The Awesome Portfolio, you are free to speculate with the remaining 10%.
The guidance provided earlier, regarding selling losing stocks and adding to winners, is specifically tailored to your "fun" account. It is advisable for everyone to have such an account, but remember to limit it to 10% of your investable assets. (Please exercise caution and never speculate with funds you cannot afford to lose.)
While the chances of making substantial profits in this account are uncertain, there is always the possibility of achieving remarkable success. So, why not shoot your shot?
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