You may have heard the expression “cut your losses early” before. This is probably the most profound wisdom for stock investors. The table below will illustrate the reason behind this insight.
The table shows that it is exponentially harder to recover from the decline in stock value. For example:
- If a stock loses 10% of its value, it only takes a gain of 11% to make up the loss.
- If a stock loses 20% of its value, it takes more effort at a gain of 25% to make up the loss.
- If a stock loses 50% of its value, it takes improbable gain of 100% to make up the loss.
- If a stock loses 90% of its value, it takes impossible gain of 900% to make up the loss.
This is why stop-loss order of 10-20% below the price at which you bought is recommended. It takes enormous effort to recover from anything greater than that.
In response to a comment on Reddit, I would like to add:
- Before you sell, you should do your due diligence and identify the underlying reason of the decline. It doesn’t make sense to simply sell because the stock value dropped.
- This main point of this demonstration is to address the false believe that it only takes 30% gain to make up for 30% loss, etc. In term of dollar amount, it only takes a $5 gain to make up a $5 loss.
- How often do you see a stock that is badly beaten (i.e., dropped 20% or more) recover in a very short period of time? Instead of hanging on, the stock could be sold for tax-loss harvesting and reinvest in other stocks (even similar ones — i.e., as I have done when I sold SSREX and bought VNQ).
Pinyo is the owner of Moolanomy Personal Finance and a Realtor® licensed in Virginia and Maryland. Over the past 20 years, Pinyo has enjoyed a diverse career as an investor, entrepreneur, business executive, educator, financial literacy author, and Realtor®.