Cut Losses Short

Defense may win games, as the sports cliché goes, but it’s offense that fires the imagination. I’m willing to bet that for every kid who dreams of making a big defensive play, there are a dozen who want to hit the walk-off home run, throw (or catch) the game-winning TD pass or sink the three-pointer at the buzzer.

Similarly, I doubt that there are many stock investors who dream of bragging about how much they have limited their losses by being in cash as markets have declined. 

Well, they should.

The one thing that many investors forget is that the market isn’t really neutral. The market actually wants to take your money away! If you’re an individual investor, you’re up against an unholy alliance of hedge fund managers, mutual fund managers and institutional investors who spend every hour of every working day looking for the little advantage that will allow them to beat their assigned benchmark index.

And there’s nothing that pleases them more than for individual investors to bid up growth stocks that are already too high (allowing the pros to sell near the top) and to hold on to stocks way too long into their declines (setting up even better buys at the bottom).

As individual investors, especially the growth stock investors that I write for, you have to have a strategy that will keep you from being a major contributor to someone else’s stock gains. The best one I know is yet another cliché: Cut your losses short.

Chairman Mao may have said it best: “When the enemy advances, we retreat. When he retreats, we advance.” It’s the quickest summary of effective guerilla war ever penned, and Mao used it to good advantage in his various campaigns against foes both foreign and domestic.

But if you just substitute growth investing for guerilla war and a bear market for the enemy, it works just as well. Mao was warning that a small force shouldn’t try to dig in and fight it out against a larger one. But his logic works equally well for an individual investor under assault by a bear market. 

It sounds too obvious to be of much use, but that’s the genius of it. 

When the bears are in charge and the market is going down…get out! The worst bear market in the world can’t take away money that you have in cash.

So if it’s so obvious, why don’t more people do it? The answer is that we’re trapped by our own psychology. It’s a well-documented truth that people are unwilling to sell a position in which they have a loss.

Somehow the selling makes it official and forces a person to face failure. I think it was Charlie Brown who said that no problem is too big to be run away from. Good thing he’s not an investor. But even if he were, he’d have plenty of company. I’ve heard so many people say things like: “That stock has fallen way too low to sell” that it makes my head spin.

Someone once called second marriages “the triumph of hope over experience.” Well, it’s okay to allow hope to be in charge when you buy a stock. But when one of your holdings tumbles, you’d better be able to put hope in your pocket and kick the offender out of your portfolio before the damage is too great. The Cabot growth stock guidelines set loss limits at 20% below your buy price when markets are healthy, and 15% when the bears are in charge. 

Of course selling stocks is hard! If it were easy, everyone would do it. There’s a reason the rules for selling are called your sell disciplines. Discipline is hard. However…no discipline, no profits.

If you get only one tattoo this year, this should be it. Cut Your Losses Short.

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