In the battle for investment survival, you can learn a lot from judo. The first and most important lesson in that martial art is the same for the stock market today: damage control.
And it's especially true when the market is heading into a major correction, such as the coronavirus stock market crash that began on Feb. 25, 2020, as the IBD Big Picture column noted the same day.
Judo masters begin not by learning how to throw, but how to fall. They practice this skill until it's as natural as breathing. No matter how many times they're flipped, they can rise to fight again.
Highly successful stock pickers go through similar training: They must learn how to cut their losses short. This means selling a stock when it's down 7% or 8% from your purchase price.
Sounds simple, but many investors have learned the hard way how difficult it is to master the most important rule in investing.
No one wants to sell for a loss. It's an admission that you made a mistake. But if you can set your ego aside, you can take a small loss and still be fit enough, both financially and mentally, to invest the next day. Cutting losses quickly prevents you from suffering a devastating fall that's too steep to recover from.
Consider the math. Say you buy a stock at 50. For whatever reason, it drops 8% to 46 during the next few days. You promptly unload it and move on. To reclaim that loss, you need to make an 8.7% gain on your next purchase with your remaining capital, which shouldn't be hard to do.
What if you hold on?
You're sure the stock will snap back. Your research convinces you it's worth $100, so why get scared by a minor setback?
There's one problem. The market doesn't care who you are, what you think, or how much you believe in a stock. It says you miscalculated, at least in the short term — a message that gets louder as the stock drops 25% to 37-1/2. To get back even, now you need a 33% gain, which is much tougher to come by than that easy 8.7%.
What if the market really doesn't like your stock and slices it in half to 25? You don't need a calculator for this one: To recover a 50% loss requires a 100% gain. How many stocks did you pick last year that doubled in price?
Let's look at an example: Arista Networks (ANET).
In the week ended Aug. 24, 2018, the specialist in gigabit-speed data switches used in data centers cleared a 311.77 buy point in a sloppy base. That base was also late stage, and thus high-risk. Arista rose no more than 2 points above the entry, calculated by adding 10 cents above the base's prior high of 311.67. Then it headed south fast.
Cutting losses at 7% meant exiting Arista near 289.95 in early September that year. The stock kept sliding. By the end of December, shares reached as low as 187.08, or 40% below the original buy point.
If you limit losses on initial purchases to 7% or 8%, you can stay out of trouble, even if only one out of four buys delivers a modest profit of 25% or 30%. You can be wrong three out of every four times and still live to invest another day.
So in sum, you can only blame yourself. One has to be disciplined and know when to cut losses and not be greedy.
DYODD and invest safely.
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