Investing 101: When to Give Up on a Losing Stock
It's really a sad time and no one can really understand it. I think more tears have been shed over declining stocks than cash lost on a hand of poker at a casino. Maybe because one is a long, slow drawn-out process and the other is quick, yet neither are painless. However, sometimes the worst may be over and you just don't know it!
Stocks go up and down all the time, and unless you have a tough stomach I highly advise that you only check your portfolio a few times per year to see how things are going. It is normal for a stock to lose value from time to time but in the end you should end up with more than when you started.
However, there are some times when you just cannot save a sinking ship.
One of the most common questions I get from investors of all ages is "How do I know when it's time to give up and take a loss on a stock that's losing me money?". The answer is of course multi-faceted, but hopefully this will give you a better understanding of when it's time to suck it up and take a big loss before you lose everything.
1. The Stock Reaches Your "Stop Loss"
This is a very easy way to make sure that a stock will never lose more than you can afford to lose. A stop loss is the minimum price you are willing to let a stock decline to before you cut your losses and sell; most brokerage accounts have this ability automatically built in, but some people like to eyeball the values and make a decision for themselves on an intra-day basis. For example, a stock may get news in the morning which causes it to drop substantially below your stop-loss, but it may recover and even reach positive returns by the afternoon. If the system was automatic, you will have lost a lot of money. Making a mental note about what your downside risk is to any stock is very important. If you are an active trader, this is a good strategy to use.
2. The Company's Fundamentals Have Changed For the Worse
Equities can have adverse reactions to news and earnings events, but that does not necessarily mean that the company is doomed. If Google's stock dropped 10% in a day, you would not necessarily think that the company is doomed, right? Of course not, because it's a stable company with plenty of long-term growth. Knowing why you bought a stock in the first place is very helpful - it should be because the company will keep gaining value over time and there is nothing in the foreseeable future that will upset this balance. However, if a company like Blockbuster dropped 10%, you would do best to examine the fundamentals: people no longer rent VHS and DVDs, they now stream movies through their television providers, Netflix, Hulu, Amazon, etc. This is a dead industry with no hope for recovery (and it did die off). Understand what drives each company forward into the future; if it's going to collapse, get out of the stock now.
3. The Company Declared Bankruptcy
Now, I pray you had the foresight to see this coming (*cough* Blockbuster *cough*) but sometimes there are situations where the company will declare bankruptcy with only a few signs in advance. If you missed the boat and the stock is still collapsing, go ahead and sell it - there's no hope it will come back. Chapter 11 simply means the company will be restructuring and there will be a LOT of pain in the near-term. Recall that this is what American Airlines had to do after 9/11 and now it's back and sturdy. Chapter 9 means the company will completely dissolve its assets and it's pretty much over - get out of this stock as soon as you can. Educate yourself a bit on the different types of bankruptcy and understand that there are big differences.
Soon I will share another article on what you can do to learn from these mistakes and plan ahead for the future.
In the end, it's important to remember that selling a stock at a loss is not the end of the world and surely if you keep investing, you will more than make up the difference with big winners in the long-run. Can't say that will happen in a game of poker!