The secret to limiting investment losses

Limiting losses on your investments is one of the most important things you can do to increase your investment returns.

It is so important that Warren Buffett called it the first and most important rule of investing.

In this article I want to give you a few valuable rules you can use to not only keep your investment losses small but to also give you ideas on how to formulate your own selling strategy.

Your reason for making the investment

Once you have done your homework on a company, write down your reason for buying.

This does not have to be long, a few sentences or a short paragraph is all you need.

Should the share price decline more than 15%, re-evaluate the company to see if the original reason for buying is still in place.

If your original reason for buying has not changed, either buy more (if you are really convinced you have a winner) or remain invested.

You can also ask a friend or other trusted investor to take a fresh look at the company to see if they come to the same conclusion. This is a great way to objectively test your reasons for staying invested.

Another rule you may want to consider.

After confirming your analysis the position is never a hold. It's always a buy or sell - the company has either become more attractive or it has not.

If your evaluation after the drop in price shows that you were wrong about the reason for investing, you should exit the position with no questions asked.

Never invent new reasons to hold a position when the original reasons are no longer applicable.

Holding onto a losing investment just to recover your initial capital is, in most cases, a recipe for even greater losses.

When your nerves can't take it any more

Have you ever bought a share that has taken you for an emotional roller-coaster ride?

Instead of small daily price movements the price dips and bounces wildly.

If holding the share makes you so uncomfortable that you can't sleep and you only worry about how much money you have lost or made in a single day you are being distracted.

Should that be the case, consider holding less volatile shares or decrease the size of your position.

Know yourself. Don't hold shares that you can't hold comfortably.

Percentage drop in price

This strategy is the simplest of all, but is a lot more difficult to implement than it looks.

Sell after a fixed percentage decline in price.

This level can be set at whatever level you feel comfortable with.

From experience I can say that sticking to such a strategy is much more challenging than it may seem at first.

After losing more than 50% on more investments than I care to mention I have implemented this rule as follows.

After a loss larger than 15% I re-evaluate the investment and either decide to hold or increase the position.

Should the loss exceed 25% I sell the position, no questions asked, as something is going on that I do not understand.

Leave emotions out of it

Should it happen that management really makes you angry, you may want to put the investment away for a while and not do anything you may regret later.

Try not to take action just because of your emotions.

It has happened in the past that the management decisions made me angry, by voting through a takeover defence, for example.

My natural reaction would be to just sell the investment and move on, but if I had reacted in that emotional state, it would have cost me a lot of money.

If you take action because of an emotional reaction, it is likely that a lot of other investors are thinking exactly the same.

This means that everyone is abandoning the investment at exactly the same time.

I have found it better to wait a while, even if I am still angry and sell the investment once the emotional selling has stopped. In most cases I have also received a higher price.

The secret to limiting investment losses

By: Tim du Toit

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