Why the #1 Rule is the #1 Rule
But You Still Have to Take Some Heat

With the market having hit a pothole last Wednesday and Thursday, it’s a good time to review what I consider the #1 rule for growth stock investors–cutting losses short. Interestingly, I remember a conversation I had back in 2003 with Carlton Lutts, our founder and a great investor, asking him what he thought was the most important “rule or tool” (as we call it in-house) and he said it was letting winners run. That was classic Carlton; without some big winners you’re never going to make any big money in the market, which I totally agree with. But I still think that protecting capital is the first step, at least for the vast majority of investors.

No matter what rule you’re talking about, though, most investors only learn to follow it after being burned a few times. I can’t tell you how many emails I’ve gotten from subscribers that say something like “Man, it took me a few years to really appreciate it, but after riding a bunch of stocks down 50% or 60%, I’ve finally learned to let stuff go quickly when it’s not working out.” As an advisor, that warms my heart because cutting losses is really the quickest and easiest thing you can do to improve your results. I’ve seen it dozens of times.

However, in this Wealth Advisory, I wanted to explain why cutting losses is so vital … but also why taking the idea to an extreme can be counterproductive. And, of course, I’ll also tie in some dos and don’ts when it comes to setting your loss limit.

But first, let’s start with why cutting losses is important. It all revolves around the Loss Curve, which displays just how unfair investing really is:

The bottom row refers to the size of the loss, while the left hand values refer to the amount needed to gain to get back to break-even.

Simply put, the more you lose—whether it’s a single trade or the value of your overall portfolio—the harder it is to get back to break-even, never mind set new highs. A 10% loss isn’t hard to recover from, relatively speaking; if your $10,000 turns into $9,000 (a 10% drop), you have to make 11.1% on that remaining money to get back to even.

Yet as the losses steepen, so does the recovery necessary to get your money back. A 20% drop means you have to make 25% on what’s left to get back to even; if you hold onto a 25% loser, it’s going to take 33% to return to where you were; a 33% drop requires a 50% gain; and a 50% loss means you have to double your money … again, just to get back to where you started. And from there, the numbers only get more daunting!

Now, if you’re a value investor who owns 25, 30 or 35 stocks, maybe the occasional big loss isn’t a big deal. But if you run a concentrated portfolio like I do (generally between 8 and 12 stocks when fully invested), a couple of 40% or 50% losers can be devastating, not just to your overall account value but possibly more damaging-to your psyche.

My experience is that investors who don’t routinely watch their risk and cut losses short spend a lot of time and energy simply trying to get back to some previous high-water mark in their portfolio. The classic example was 2008, which caused such major losses that most investors are still no wealthier than they were back in 2007; more than five years later many are just wishing to get back to that prior peak. But even in lesser downturns, too many investors let their portfolio fade by 15%, 20% or more, usually because they hold on to some stinkers, failing to get out when they should.

Of course, there are other reasons investors struggle (including poor stock selection, which I wrote about in my last Wealth Advisory), but I think the unwillingness to admit they’re wrong and take small losses is the #1 reason many investors put up poor returns. And that’s why cutting losses short is my #1 rule for growth stock investing.

Now, I’ve been writing about the value of cutting losses since I started at Cabot in June 1999, and thankfully many of you have listened, adjusted and benefited. But soon after somebody converts to making sure no loss gets out of control, I often get an email like this:

“OK Mike, I hear you loud and clear about cutting losses; in fact, I haven’t taken a loss of more than 10% during the past few months. Yet my overall portfolio has done nothing but head south during that time–it seems like all my trades end up in losses, even though I own some good stocks. Help!”

I often go back and forth for a bit and maybe chat on the phone to get a better idea of what he’s doing wrong. And eight times out of 10, the answer is that, instead of being numb to losses like they were before, they’ve become hypersensitive to them!

The classic example is the investor who does some research, likes a story and chart, and goes ahead and takes the plunge. Then, two days later, some analyst downgrades the stock or the market has a nasty selloff, and the stock falls a few points and he bails out; the stock didn’t hit his loss limit, but he gets nervous and sells.

Another pitfall is what I call the square-peg-round-hole problem when it comes to loss limits. Some investors will buy Home Depot, a relatively steady stock, and use a 10% loss limit. But then they’ll buy Netflix and use the same 10% loss limit … even though the latter stock is two or three times as volatile as Home Depot! The result is that many investors will get knocked out on what is effectively “noise”-the stock didn’t really do anything abnormal, but it forced the buyer out.

Both of these problems boil down to one fact: In the stock market, you have to be willing to take some heat. Nobody is going to be able to buy stocks that simply go up, up, up as soon as they take a position. Sure, you’ll occasionally catch a tiger by the tail, but as any trend-following investor during the past two years can tell you, there will be plenty of times a stock bobs-and-weaves for two or three weeks before getting moving.

Right about now, you might be completely confused; in the first section I told you that cutting losses is rule #1, but right now, I’m telling you sometimes people get into trouble by cutting losses too tightly. But the solution isn’t convoluted; the idea is to plan where your loss limit will be BEFORE you make the trade (and, secondarily, how you’re going to trail a mental stop) … but then be comfortable losing that amount if necessary, unless something clearly changes (market timing turns negative, etc.).

Many investors tell themselves they’re comfortable losing 10% or 12% or whatever the number is, but then once the stock falls 5% they’re panicking and want out. It’s kind of like the casual casino player who brings a wad of $700 to gamble with, but as soon as he’s down $250 after a bad run at craps, he heads to the bar … often just before the table turns hot. I can tell you that’s a big no-no, as you’ll end up owning a bunch of winners but will actually lose money on the trades because you forced yourself out too early.

Honestly, I could write for hours about things like stop placements, portfolio management and the like; in fact, I’m thinking one of my main presentations at the Cabot Investors Conference this August (email me for details) will be about those topics. For now, though, suffice to say that it’s vital to cut ALL losses short if you’re running a concentrated portfolio … but to also give stocks room to breathe for a few weeks as long as they don’t trip your pre-determined loss limit.