Before we get started, I want to welcome the +55 subscribers who signed up for the Let’s Analyze newsletter in the last week! If you want to join our community, make sure to sign up here:
All of you are reading this newsletter to learn how to make money.
Which is why this is going to sound so strange, but making money should not be your main goal.
Instead, not losing money should be your goal…
…because if you keep your losses small, the upside will take care of itself.
The Virtues of Minimizing Losses
Every great investor talks about keeping losses small.
Warren Buffett famously said…
Billionaire hedge fund manager Paul Tudor Jones said…
And one of my personal favorites, Jeff Saut, recently said in his newsletter…
“Over my 50+ years in this business, and longer than that of buying stocks, the most important thing you can do is limit your losses.”
Everyone wants to focus on how to make money. And to get that “home run” trade.
But especially for new investors, your focus should be on not losing money.
As the math is not in the loser’s favor.
Don’t Be “That Guy”
A lot of new investors hold onto losing positions longer than they should.
For instance, a member of my Patreon discord bought shares in the Chinese electric car company Nio Inc. in 2022 (not on my recommendation as I’ve long avoided Chinese stocks):
When he sent this message, Andrew was down 31% on his position in only a few weeks:
Yet he still didn’t want to sell as selling for a loss that big seemed “useless.”
But between the time he posted this message and today, Nio fell nearly 60%…
Hindsight is always 20/20 when it comes to selling a stock. But as a personal rule, I automatically sell any position that falls more than 25%.
Because after that level, the math really starts working against you.
Keeping the Math on Your Side
The table below shows that the more your losses increase, the gains required to breakeven increase exponentially…
…And the math gets less favorable the more you lose.
For example, if a position in your portfolio falls by 50%, that position needs to rise 100% just to breakeven. And if a portfolio position falls 90%, you need to make a 900% gain just to get back to even.
For Andrew, he could have sold his position in Nio for a 30% loss and reallocated to something with more upside (which is what I suggested all my Patreon members do in early 2022).
This is why minimizing losses is so important. If you can avoid big losses, you can avoid the need for big gains just to breakeven.
But there’s actually a psychological reason why people don’t do this.
Don’t Fall Into this Investing Trap
There is a common behavioral finance trap many new investors fall into called the disposition effect.
The disposition effect is when investors are reluctant to sell stocks that are down but more likely to sell stocks that have gone up.
Let’s say you bought two stocks: Apple and the Nio. Your Apple stock rises 8% and your Nio shares fall 20%. What would you do in this situation?
Many people would take their small 8% gain on Apple – a solid, blue-chip stock – to “buy the dip” on Nio.
Well, I hate to tell you, but you’re almost always better off taking the -20% loss and buying more Apple shares – even though you’ll be buying at higher prices.
While it seems illogical, it has deep roots in human nature: people enjoy winning and hate losing. Nobody wants to take a loss, especially if there’s a “prospect” the stock could bounce back in the future.
A Word to the Wise
While it’s a hard lesson to learn, you don't do yourself any favors by hanging onto losing positions.
And when I see people in our investing community doing this, I often send them this quote from Peter Lynch:
Holding losing positions you’ve lost faith in hoping they will “bounce back” is a recipe for disaster. You have to be hard on your losers, which is why I have a rule to cut any position that falls 25% or more.
Because the more you let the position fall, the more unlikely it is to hit a new high.
Instead of succumbing to the disposition effect, the best thing to do is cut your position and move on.
So don’t forget rule #1: don’t lose money. And if you do, don’t fall under the spell of the disposition effect.
Stay safe out there,
Robert