Number One Lesson in Investing

People wonder all the time what to invest in. There is a dizzying array of investments and it can be boggling trying to decide what will be a winner. But there is something more important to worry about. It is, in fact, THE MOST IMPORTANT THING TO KNOW ABOUT INVESTING.

I’m speaking about knowing when to get out of an investment. As a new investor, you are going to experience some small losses. You cannot be right all the time and these losses are sort of the “tuition” of investing success. But there is a point in any loss when you have to admit that you must bail, or risk losing more than your shirt.

Because of ego, we tend to hold. It is hard for us to believe that we would make a serious mistake, when we have all the online research tools, apps for our phones, etc. You go in to investing to make money, so selling at a loss is very hard thing to do. It’s worse if a stock rebounds after you’ve sold, making you feel like a schmuck. So you have to apply a little self-examination on how you view losses.

It’s like car insurance. You don’t begrudge the net-loss paid out for insurance you never use, do you? Instead you buy it, and get nothing back, so you are covered if  something goes wrong. Controlling a loss when an investment goes the wrong way is the same thing.

You cannot stop losses from happening; they are inevitable, especially in the beginning. So what I’m talking about here is being in control of your losses, instead of being at their mercy. You don’t wait for the investment to tank and fall over the cliff. Instead, have a plan to get out if needed – an insurance policy, if you will.

So what works? It is different for everybody, since each investor has his or her own risk tolerance. But in general, a 7-10% loss against purchase price is a good control point. Let’s call it 8% hereafter.

Remember, emotion is out. This is purely a numbers game. What you must avoid is getting emotional with a stock, being blinded to your mistakes and holding for too long. You vacillate, and then it’s too late. Now, you get discouraged at your big loss and lose confidence. So let me give you an old adage from William O’Neal: “Sell down to the sleeping point.”

This means that if things are going downhill with an investment, but you cannot break off from it, you don’t have to sell it all – just sell enough so you can sleep at night.

Cutting your losses at 7-8% is also better than waiting to reach a 50% loss – when you must then recover by 100% just to break even! Once you get good at this investing stuff, you can sell some of your others when they are high, which will let you be wrong now and then and still not get into the red. This also implies that your better performing stocks should always be held longer than your worst ones. Call that a bonus tip.

You expect to have some minor losses – but you also intend to persevere. Discouragement is not in your vocabulary, because you know it takes persistence to get good at this. Follow this one lesson and soon you will win more than you lose. If any one asks, you can now say that you have a formula: You never have greater than an 8% risk in any stock, ever. Whether it is a top blue chip or an edgy tech stock, your risk is always the same.

Inspired by “24 Essential Lessons for Investing Success,” by William J. O’neal

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