Cutting Your Losses -- Rules to Live By

 | Jan 11, 2012 | 9:00 AM EST  | Comments
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wynn

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arco

When I saw shares of Tiffany (TIF) crater 10.5% Tuesday to $59.94 in huge volume, I was reminded why it's a good idea to have sell rules in place after buying a stock.

I bought shares of Tiffany Oct. 27 when it gapped up above a swing point of $77.84. I wasn't thrilled when the stock finished in the bottom half of its trading range for the day, because it told me that sellers were around. Still, I wanted to give it some room.

Pretty soon, though, I realized a breakout didn't have much chance of working, so I decided to cut losses short and move. I sold on Nov. 21, when the stock was trading around $72.50. The loss stung, but I invest in growth stocks. I know taking losses is part of the game. Not all buys are going to work, and failed breakouts can get ugly quickly.

The majority of investors don't have sell rules, but I've always found them useful because they help me sleep easier at night. For example, I never let a stock fall more than 10% below my purchase price. In an uncertain market, where an uptrend isn't clearly defined yet, I generally limit losses to 4% to 5% below my purchase price. I basically have an insurance policy with every stock I buy.

Of course, sell rules can be frustrating, especially when you cut a loss short only to see the stock soar higher again. It happens. But in the end, keeping losses small allows you stay in the game.

Other good sells in recent months for me include Wynn Resorts (WYNN) on May 16, when shares were trading around $144. Another is Arcos Dorados (ARCO),which I bought on Sept. 21, when it was quoted around $25.50.

I also use sell rules when I'm in profitable positions. I generally will take a 20% gain in a stock when I have I have one, unless I feel like I have a potential big leader on my hands still in the early stages of an upward move. An example would be a recent initial public offering with top-notch fundamentals that mutual fund managers are still discovering. Breakouts from early-stage bases can be launching pads for big gains.

I'm also not afraid to take profits when I start to see signs of institutional selling in a stock. Low-volume declines are one thing, but when volume starts to pick up on the downside, it can be a sign that institutions are starting to dump shares. Recognizing early signs of institutional selling in a stock is a valuable part of any technician's arsenal.

I currently have several profitable positions in my model growth portfolio. Even though I'm still cautious on the market, in these cases I'm still seeing good performance. There's no reason to be too quick on the trigger.

I've said it before and I'll say it again: It's just as gratifying selling a stock at the right time as it is buying at the right time. A big loss can cripple a portfolio, whereas small losses can easily be overcome. Of course, keep in mind that a series of small losses can also do damage to a portfolio. If I'm forced to cut losses three times in a row in a stock, the market's message is pretty clear: It's not the right time to be buying stocks.

The ultimate goal is buy a stock at the right time and hold for a long-term gain. It's much easier to do in the early stages of a bull market, rather than the later stages of one. What's tricky about the current market is that, even though major averages are on an uptrend, the low volume means there's still a lot of money on the sidelines. My hope is that recent breakouts in my model portfolio have staying power, but if institutional selling starts to pick up in the market again -- which is a distinct possibility --recent breakouts won't have much chance of succeeding.

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