Expert Traders Have Small Losses
While it is true that the expert trader keeps his losses small in order to control risk and also to prevent them from canceling out his larger gains, there is yet another reason to keep losses small. Perhaps a little illustration will give some clarity to this extra benefit..
Let’s suppose that you have a portfolio of ten stocks and that each of those stocks has moved up a little since they were purchased a few days ago, with the exception of one stock. Assume you bought that stock for $10 a share when it was right on a rising trendline. After you bought the stock, it declined to $9. You bought the stock in expectation that it would rise because of the presence of the rising trendline, and by definition a trendline represents support. The fact that it did not rise but declined instead means that the original reason for purchasing is no longer valid. To keep holding the stock in the hope that it will recover is an act of self-delusion or unwillingness to admit that you made a trade that did not work. For whatever reason, the stock is still in your portfolio.
Now, you notice that another stock on your watch list has just broken out above its trading range on heavy volume. You would like to buy it but you are fully invested at the moment. Therefore, the under-performing stock is really giving you a triple whammy. First, it has lost value rather than gain value. Second, it is canceling out the gain of one of your other stocks so that you effectively have only eight stocks that are enhancing the value of your portfolio rather than nine. Third, it is preventing you from taking advantage of a new opportunity that might actually appreciate in value and result in your having ten appreciating positions rather than your current eight.
If it is your habit to hold a stock that breaks below support like the stock in this illustration, then this is by no means the worst-case scenario. It is typical for such investors to have maybe four or five stocks that are not performing as expected. Usually, they will say something like “I am an investor, not a trader,” as if that makes their utter refusal to manage their portfolio a virtue. The portfolio is dead in the water! The goal should not be to avoid being a “trader.” It should be to make money! On the other hand, if you have a habit of selling stocks that do not fulfill your original reason for purchasing them, then you will be much more likely to have money available to take advantage of a new opportunity. If the money is not available, it is because you are fully invested in stocks that are actively adding value to your portfolio.
When a stock breaks below a support line, it will tend to drift lower, not reverse and return to your purchase price. By definition, that line of support represents an accumulation of buyers at that level. If the stock declines through that support, it means that the selling volume overwhelmed the demand for the stock. After that happens, the stock is no longer above support. There are few buyers interested in owning it. Those that might have had an interest just saw the stock break through all that support. They will be likely to wait to see how far the stock will drop before they commit their money. That is what our own stockdisciplines.com traders would do. Once a stock breaks support, we always wait to see where and if it gets new support before we buy it. The stock may decline another 5%, 10%, or even more before it reaches new support. Therefore, there is no wisdom in continuing to hold once a stock declines through support.
You must always minimize losses and preserve capital through proper portfolio management. Buying stocks and holding them regardless of what they do is mot proper portfolio management. It is portfolio neglect. “Proper” management results in your having the maximum amount of money available when opportunities arise, and it avoids a situation in which the gains of your top performing stocks are neutralized by the losses of declining stocks.