How to avoid disastrous stock declines

A common phenomenon that happens to all investors. Having bought a stock, how do we handle declines? Here are a few thoughts and ideas posted from the blog post that originally appeared here. While these may be talking about US stocks, the underlying philosophy applies to all investors be they in New York or London or Singapore or even in Mumbai.

• Avoid falling in love with a company or its stock. The emotional attachment will cloud your judgement and prevent you from making sound decisions in the market. The “pet stock” phenomenon occurs more often than you may think.

• Are you a long-term fundamental investor or a price-based trader? Know your methodology and your reason for getting into a trade or a particular investment. As the saying goes, it’s often easier to buy a stock than to know when to sell it. It’s even more difficult to exit a losing position when you begin shifting strategies late in the game. The recent market decline has turned many once-confident “bargain hunters” into panicked sellers.
• Use a simple moving average to guide your selling decisions. For example (and this is a rough guide, not a foolproof method), you may decide to sell once your stock closes below its 200 day moving average. Or you may decide to sell when the stock breaches a prior support level. Stocks go through a life cycle of boom and bust (see Stan Weinstein’s stage analysis). You want to ride the uptrends and, ideally, sell near tops or in the early stages of a downtrend. If you can clearly differentiate between the accumulation and distribution phases of a stock’s life cycle, it will help guide your buy and sell decisions.
• If trading off charts isn’t your thing, at least limit your losses to 10% or 15%. Predetermined loss limits can help you take the emotion out of selling. Smaller losses make it easier to get back in the game. Large losses require huge, ever-increasing gains to make it back to your break-even point.
• Don’t add to your losing trades in an effort to “average down” at a lower price. While you may see many big-name investors do just that, remember that they are often playing with other people’s money (or taking big risks with their own capital). This is a strategy that can lead to ruin, especially when an investor becomes convinced that their favorite stock is now “cheap” or has been unjustly punished by the market. Remember, “cheap” can get much cheaper than you imagined. Billionaires can usually regroup after a $100 million mistake. What will happen to you if you lose $100 thousand?
• Study charts of stocks that had similar boom and bust cycles. Many leading stocks have been pummeled in bear markets or lost most of their value once their high-growth phase petered out. If you study enough of these charts, you’ll begin to see warning signs that may help you avoid future declines. William O’Neil’s books are a great resource in this area.