CHAPTER 10
When You Must Sell and Cut Every Loss . . . without Exception

Now that you’ve learned how and when to buy nothing but the best stocks, it’s time for you to learn how and when to sell them. You’ve probably heard the sports cliché: “The best offense is a strong defense.” The funny thing about clichés is they are usually true: a team that’s all offense and no defense seldom wins the game. In fact, a strong defense can often propel a team to great heights.

During their heyday, when Branch Rickey was president and general manager, the Brooklyn Dodgers typically had good pitching. In the game of baseball, the combination of pitching and fielding represents the defensive side of a team and maybe 70% of the game. It’s almost impossible to win without them.

The same holds true in the stock market. Unless you have a strong defense to protect yourself against large losses, you absolutely can’t win big in the game of investing.

Bernard Baruch’s Secret Market Method of Making Millions

Bernard Baruch, a famous market operator on Wall Street and trusted advisor to U.S. presidents, said it best: “If a speculator is correct half of the time, he is hitting a good average. Even being right 3 or 4 times out of 10 should yield a person a fortune if he has the sense to cut his losses quickly on the ventures where he has been wrong.”

As you can see, even the most successful investors make many mistakes. These poor decisions will lead to losses, some of which can become quite awful if you’re not disciplined and careful. No matter how smart you are, how high your IQ, how advanced your education, how good your information, or how sound your analysis, you’re simply not going to be right all the time. In fact, you’ll probably be right less than half the time! You positively must understand and accept that the first rule for the highly successful individual investor is . . . always cut short and limit every single loss. To do this takes never-ending discipline and courage.

Marc Mandell of Winning on Wall Street has been reading Investor’s Business Daily since 1987. He likes it for its many moneymaking ideas and its emphasis on risk-management strategies. “Lose small and win big,” he believes, “is the holy grail of investing.”

Baruch’s point about cutting losses was driven home to me by an account that I managed back in 1962. The general market had taken a 29% nosedive, and we were right on only one of every three commitments we had made in this account. Yet at the end of the year, the account was ahead. The reason was that the average profit on the 33% of decisions that were correct was more than twice the average of the small losses we took when we were off-target.

I like to follow a 3-to-1 ratio between where to sell and take profits and where to cut losses. If you take some 20% to 25% gains, cut your losses at 7% or 8%. If you’re in a bear market like 2008 and you buy any stocks at all, you might get only a few 10% or 15% gains, so I’d move quickly to cut every single loss automatically at 3%, with no exceptions.

The whole secret to winning big in the stock market is not to be right all the time, but to lose the least amount possible when you’re wrong.

You’ve got to recognize when you may be wrong and sell without hesitation to cut short every one of your losses. It’s your job to get in phase with the market and not try to get the market in phase with you.

How can you tell when you may be wrong? That’s easy: the price of the stock drops below the price you paid for it! Each point your favorite brainchild falls below your cost increases both the chance you’re wrong and the price you’re going to pay for being wrong. So get realistic.

Are Successful People Lucky or Always Right?

People think in order to be successful, you have to be either lucky or right most of the time. Not so. Successful people make many mistakes, and their success is due to hard work, not luck. They just try harder and more often than the average person. There aren’t many overnight successes; success takes time.

In search of a filament for his electric lamp, Thomas Edison carbonized and tested 6,000 specimens of bamboo. Three of them worked. Before that, he had tried thousands of other materials, from cotton thread to chicken feathers.

Babe Ruth worked so hard for his home run record that he also held the lifetime record for strikeouts. Irving Berlin wrote more than 600 songs, but no more than 50 were hits. The Beatles were turned down by every record company in England before they made it big. Michael Jordan was once cut from his high school basketball team, and Albert Einstein made an F in math. (It also took him many years to develop and prove his theory of relativity.)

It takes a lot of trial and error before you can nail down substantial gains in stocks like Brunswick and Great Western Financial when they doubled in 1961, Chrysler and Syntex in 1963, Fairchild Camera and Polaroid in 1965, Control Data in 1967, Levitz Furniture in 1970–1972, Prime Computer and Humana in 1977–1981, MCI Communications in 1981–1982, Price Company in 1982–1983, Microsoft in 1986–1992, Amgen in 1990–1991, International Game Technology in 1991–1993, Cisco Systems from 1995 to 2000, America Online and Charles Schwab in 1998–1999, and Qualcomm in 1999. These stocks dazzled the market with gains ranging from 100% to more than 1,000%.

Over the years, I’ve found that only one or two out of ten stocks that I’ve bought turned out to be truly outstanding and capable of making this kind of substantial profits. In other words, to get the one or two stocks that make big money, you have to look for and buy ten.

Which begs the question, what do you do with the other eight? Do you sit with them and hope, the way most people do? Or do you sell them and keep trying until you come up with even bigger successes?

When Does a Loss Become a Loss?

When you say, “I can’t sell my stock because I don’t want to take a loss,” you assume that what you want has some bearing on the situation. But the stock doesn’t know who you are, and it couldn’t care less what you hope or want.

Besides, selling doesn’t give you the loss; you already have the loss. If you think you haven’t incurred a loss until you sell the stock, you’re kidding yourself. The larger the paper loss, the more real it will become. If you paid $40 per share for 100 shares of Can’t Miss Chemical, and it’s now worth $28 per share, you have $2,800 worth of stock that cost you $4,000. You have a $1,200 loss. Whether you convert the stock to cash or hold it, it’s still worth only $2,800.

Even though you didn’t sell, you took your loss when the stock dropped in price. You’d be better off selling and going back to a cash position where you can think far more objectively.

When you’re holding on to a big loss, you’re rarely able to think straight. You get emotional. You rationalize and say, “It can’t go any lower.” However, keep in mind that there are many other stocks to choose from where your chance of recouping your loss could be greater.

Here’s another suggestion that may help you decide whether to sell: pretend that you don’t own the stock and you have $2,800 in the bank. Then ask yourself, “Do I really want to buy this stock now?” If your answer is no, then why are you holding onto it?

Always, without Exception, Limit Your Losses to 7% or 8% of Your Cost

Individual investors should definitely set firm rules limiting the loss on the initial capital they have invested in each stock to an absolute maximum of 7% or 8%. Institutional investors who lessen their overall risk by taking large positions and diversifying broadly are unable to move into and out of stocks quickly enough to follow such a loss-cutting plan. This is a terrific advantage you, the nimble decisive individual investor, have over the institutions. So use it, or lose your edge.

When the late Gerald M. Loeb of E. F. Hutton was writing his last book on the stock market, he came down to visit me in Los Angeles, and I had the pleasure of discussing this idea with him. In his first work, The Battle for Investment Survival, Loeb advocated cutting all losses at 10%. I was curious and asked him if he always followed the 10% loss policy himself. “I would hope,” he replied, “to be out long before they ever reach 10%.” Loeb made millions in the market.

Bill Astrop, president of Astrop Advisory Corp. in Atlanta, Georgia, suggests a minor revision of the 10% loss-cutting plan. He thinks that individual investors should sell half of their position in a stock if it is down 5% from their cost and the other half once it’s down 10%. This is sound advice.

To preserve your hard-earned money, I think a 7% or 8% loss should be the absolute limit. The average of all your losses should be less, perhaps 5% or 6%, if you’re strictly disciplined and fast on your feet. If you can keep the average of all your mistakes and losses to 5% or 6%, you’ll be like the football team on which opponents can never move the ball. If you don’t give up many first downs, how can anyone ever beat you?

Now here’s a valuable secret: if you use charts to time your buys precisely off sound bases (price consolidation areas), your stocks will rarely drop 8% from a correct buy point. So when they do, either you’ve made a mistake in your selection or a general market decline may be starting. This is a big key for your future success.

Barbara James, an IBD subscriber who has attended several of our workshops, didn’t know anything about stocks when she started investing after 20 years in the real estate business. She first traded on paper using the IBD rules. This worked so well that she finally had the confidence to try it with real money. That was in the late 1990s, when the market seemed to have only one direction—up. The first stock she bought using the IBD rules was EMC. When she sold it in 2000, she had a 1,300% gain. She also had a gain of over 200% in Gap. Ten years after her start, with the profits she made using IBD, she was able to pay off her house and her car.

And thanks to the 7% rule, Barbara can take advantage of the market once it improves. Before the market started to correct in the fall of 2007, she had bought three CAN SLIM stocks—Monolithic Power, China Medical, and St. Jude Medical. “I bought them all at exactly the right pivot point, and I got forced out of all three as the market started to correct in July and August,” she says. “I am happy to lose money when it’s only 7% or 8%. If it hadn’t been for the sell rules, I would have lost my shirt. And I wouldn’t have resources for the next bull market.”

Here’s what another IBD subscriber, Herb Mitchell, told us in February 2009: “Over and over again, the buy and sell rules—especially the sell rules—have been proven to work. It took me a couple of years to finally get it through my head, but then the results started to show. I spent most of 2008 on the sidelines, and I now get compliments from friends who say that they lost thousands—50% or more—in their IRA accounts while I had a 5% gain for the year. I think I should have done better, but you live and learn.”

Also, there’s no rule that says you have to wait until every single loss reaches 7% to 8% before you take it. On occasion, you’ll sense the general market index is under distribution (selling) or your stock isn’t acting right and you are starting off amiss. In such cases, you can cut your loss sooner, when the stock may be down only one or two points.

Before the market broke wide open in October 1987, for example, there was ample time to sell and cut losses short. That correction actually began on August 26. If you’re foolish enough to try bucking the market by buying stocks in bearish conditions, at least move your absolute loss-cutting point up to 3% or 4%.

After years of experience with this technique, your average losses should become less as your stock selection and timing improve and you learn to make small “follow-up buys” in your best stocks. It takes a lot of time to learn to make follow-up buys safely when a stock is up, but this method of money management forces you to move your money from slower-performing stocks into your stronger ones. I call this force-feeding. (See “My Revised Profit-and-Loss Plan,” pages 258–259 in Chapter 11.) You’ll end up selling stocks that are not yet down 7% or 8% because you are raising money to add to your best winners during clearly strong bull markets.

Remember: 7% to 8% is your absolute loss limit. You must sell without hesitation—no waiting a few days to see what might happen; no hoping the stock will rally back; no need to wait for the day’s market close. Nothing but the fact you’re down 7% or 8% below your cost should have a bearing on the situation at this point.

Once you’re significantly ahead and have a good profit, you can afford to give the stock a good bit more room for normal fluctuations off its price peak. Do not sell a stock just because it’s off 7% to 8% from its peak price. It’s important that you definitely understand the difference.

In one case, you probably started off wrong. The stock is not acting the way you expected it to, and it is down below your purchase price. You’re starting to lose your hard-earned money, and you may be about to lose a lot more. In the other case, you have begun correctly. The stock has acted better, and you have a significant gain. Now you’re working on a profit, so in a bull market, you can afford to give the stock more room to fluctuate so that you don’t get shaken out on a normal 10% to 15% correction.

Don’t chase your stock up too far when you’re buying it, however. The key is timing your stock purchases exactly at breakout points to minimize the chance that a stock will drop 8%. (See Chapter 2 for more on using charts to select stocks.)

All Common Stocks Are Speculative and Risky

There is considerable risk in all common stocks, regardless of their name, quality, purported blue-chip status, previous performance record, or current good earnings. Keep in mind that growth stocks can top at a time when their earnings are excellent and analysts’ estimates are still rosy.

There are no sure things or safe stocks. Any stock can go down at any time . . . and you never know how far it can go down.

Every 50% loss began as a 10% or 20% loss. Having the raw courage to sell and take your loss cheerfully is the only way you can protect yourself against the possibility of much greater devastating losses. Decision and action should be instantaneous and simultaneous. To be a big winner, you must learn to make decisions. I’ve known at least a dozen educated and otherwise intelligent people who were completely wiped out solely because they would not sell and cut a loss.

What should you do if a stock gets away from you and the loss becomes greater than 10%? This can happen to anyone, and it’s an even more critical sign the stock positively must be sold. It was in more trouble than normal, so it fell faster and further than normal. In the market collapse of 2000, many new investors lost heavily, and some of them lost it all. If they had just followed the simple sell rule discussed earlier, they would have protected most of their capital. Investing is not gambling, it is investing.

In my experience, the stocks that get away from you and produce larger-than-normal losses are the truly awful selections that absolutely must be sold. Something is really going wrong with either the stock or the whole market, and it’s even more urgent the stock be sold to avoid a later catastrophe.

Keep in mind that if you let a stock drop 50%, you must make 100% on your next stock just to break even! And how often do you buy stocks that double? You simply can’t afford to sit with a stock where the loss keeps getting worse. Get out.

It is a dangerous fallacy to assume that because a stock goes down, it has to come back up. Many don’t. Others take years to recover. AT&T hit a high of $75 in 1964 and took 20 years to come back. Also, when the S&P 500 or Dow declines 20% to 25% in a bear market, many stocks will plummet 60% to 75%.

When the S&P dives 52%, as it did in 2008, many stocks fell 80% to 90%. Who would have projected General Motors would sell for $2 a share, down from $94? The auto industry is important to the United States, but it will require a serious, top-to-bottom restructuring and will possibly have to go through bankruptcy if it is to survive and compete effectively in the new highly competitive world market. For 31 years, from 1977 to 2008, GM stock’s relative price strength line declined steadily. What will GM do in the future if India or China sells cars in the United States that get 50 miles per gallon and have a much lower price?

The only way to prevent bad stock market losses is to cut them without hesitation while they’re still small. Always protect your account so that you can live to invest successfully another day.

In 2000, many new investors incorrectly believed all you had to do was buy high-tech stocks on every dip in price because they would always go back up and there was easy money to be made. This is an amateur’s strategy, and it almost always leads to heavy losses. Semiconductor and other technology stocks are two to three times as volatile and risky as others. So if you’re in these stocks, moving rapidly to cut short every loss is even more essential. If your portfolio is in nothing but high-tech stocks, or if you’re heavily margined in tech stocks, you are asking for serious trouble if you don’t cut your losses quickly.

You should never invest on margin unless you’re willing to cut all your losses quickly. Otherwise, you could go belly-up in no time. If you get a margin call from your broker (when you’re faced with the decision to either sell stock or add money to your account to cover the lost equity in a falling stock), don’t throw good money after bad. Sell some stock, and recognize what the market and your margin clerk are trying to tell you.

Cutting Losses Is Like Buying an Insurance Policy

This policy of limiting losses is similar to paying small insurance premiums. You’re reducing your risk to precisely the level you’re comfortable with. Yes, the stock you sell will often turn right around and go back up. And yes, this can be frustrating. But when this happens, don’t ever conclude you were wrong to sell it. That exceedingly dangerous thinking will eventually get you into serious trouble.

Think about it this way: If you bought insurance on your car last year and you didn’t have an accident, was your money wasted? Will you buy the same insurance this year? Of course you will! Did you take out fire insurance on your home or your business? If your home or business hasn’t burned down, are you upset because you feel you made a bad financial decision? No. You don’t buy fire insurance because you know your house is going to burn down. You buy insurance just in case, to protect yourself against the remote possibility of a serious loss.

It’s exactly the same for the winning investor who cuts all losses quickly. It’s the only way to protect against the possible or probable chance of a much larger loss from which it may not be possible to recover.

If you hesitate and allow a loss to increase to 20%, you will need a 25% gain just to break even. Wait longer until the stock is down 25%, and you’ll have to make 33% to get even. Wait still longer until the loss is 33%, and you’ll have to make 50% to get back to the starting gate. The longer you wait, the more the math works against you, so don’t vacillate. Move immediately to cut out possible bad decisions. Develop the strict discipline to act and to always follow your selling rules.

Some people have gone so far as to let losing stocks damage their health. In this situation, it’s best to sell and stop worrying. I know a stockbroker who in 1961 bought Brunswick at $60 on the way down in price. It had been the market’s super leader since 1957, increasing more than 20 times. When it dropped to $50, he bought more, and when it dropped to $40, he added again.

When it dropped to $30, he dropped dead on the golf course.

History and human nature keep relentlessly repeating themselves in the stock market. In the fall of 2000, many investors made the identical mistake: they bought the prior bull market’s leader, Cisco Systems, on the way down at $70, $60, $50, and lower, after it had topped at $87. Seven months later it had sunk to $13, an 80% decline for those who bought at $70. The moral of the story is: never argue with the market. Your health and peace of mind are always more important than any stock.

Small losses are cheap insurance, and they’re the only insurance you can buy on your investments. Even if a stock moves up after you sell it, as many surely will, you will have accomplished your critical objective of keeping all your losses small, and you’ll still have money to try again for a winner in another stock.

Take Your Losses Quickly and Your Profits Slowly

There’s an old investment saying that the first loss in the market is the smallest. In my view, the way to make investment decisions is to always (with no exceptions) take your losses quickly and your profits slowly. Yet most investors get emotionally confused and take their profits quickly and their losses slowly.

What is your real risk in any stock you buy when you use the method we’ve discussed? It’s 8%, no matter what you buy, if you follow this rule religiously. Still, most investors stubbornly ask, “Shouldn’t we sit with stocks rather than selling and taking a loss?” Or, “How about unusual situations where some bad news hits suddenly and causes a price decline?” Or, “Does this loss-cutting procedure apply all the time, or are there exceptions, like when a company has a good new product?” The answer: there are no exceptions. None of these things changes the situation one bit. You must always protect your hard-earned pool of capital.

Letting your losses run is the most serious mistake almost all investors make. You must accept the fact that mistakes in stock selection and timing are going to be made frequently, even by the most experienced of professional investors. I’d go so far as to say that if you aren’t willing to cut short and limit your losses, you probably shouldn’t buy stocks. Would you drive your car down the street without brakes? If you were a fighter pilot, would you go into battle without a parachute?

Should You Average Down in Price?

One of the most unprofessional things a stockbroker can do is hesitate or fail to call customers whose stocks are down in price. That’s when the customer needs help the most. Shirking this duty in difficult periods shows a lack of courage under pressure. About the only thing that’s worse is for brokers to take themselves off the hook by advising customers to “average down” (buy more of a stock that is already showing a loss). If I were advised to do this, I’d close my account and look for a smarter broker.

Everyone loves to buy stocks; no one loves to sell them. As long as you hold a stock, you can still hope it might come back up enough to at least get you out even. Once you sell, you abandon all hope and accept the cold reality of temporary defeat. Investors are always hoping rather than being realistic. Knowing and acting is better than hoping or guessing. The fact that you want a stock to go up so you can at least get out even has nothing to do with the action and brutal reality of the market. The market obeys only the law of supply and demand.

A great trader once noted there are only two emotions in the market: hope and fear. “The only problem,” he added, “is we hope when we should fear, and we fear when we should hope.” This is just as true in 2009 as it was in 1909.

The Turkey Story

Many years ago, I heard a story by Fred C. Kelly, the author of Why You Win or Lose, that illustrates perfectly how the conventional investor thinks when the time comes to make a selling decision:

A little boy was walking down the road when he came upon an old man trying to catch wild turkeys. The man had a turkey trap, a crude device consisting of a big box with the door hinged at the top. This door was kept open by a prop, to which was tied a piece of twine leading back a hundred feet or more to the operator. A thin trail of corn scattered along a path lured turkeys to the box.

Once they were inside, the turkeys found an even more plentiful supply of corn. When enough turkeys had wandered into the box, the old man would jerk away the prop and let the door fall shut. Having once shut the door, he couldn’t open it again without going up to the box, and this would scare away any turkeys that were lurking outside. The time to pull away the prop was when as many turkeys as one could reasonably expect were inside.

One day he had a dozen turkeys in his box. Then one sauntered out, leaving 11. “Gosh, I wish I had pulled the string when all 12 were there,” said the old man. “I’ll wait a minute and maybe the other one will go back.” While he waited for the twelfth turkey to return, two more walked out on him. “I should have been satisfied with 11,” the trapper said. “Just as soon as I get one more back, I’ll pull the string.” Three more walked out, and still the man waited. Having once had 12 turkeys, he disliked going home with less than 8.

He couldn’t give up the idea that some of the original turkeys would return. When finally there was only one turkey left in the trap, he said, “I’ll wait until he walks out or another goes in, and then I’ll quit.” The solitary turkey went to join the others, and the man returned empty-handed.

The psychology of normal investors is not much different. They hope more turkeys will return to the box when they should fear that all the turkeys could walk out and they’ll be left with nothing.

How the Typical Investor Thinks

If you’re a typical investor, you probably keep records of your transactions. When you think about selling a stock, you probably look at your records to see what price you paid for it. If you have a profit, you may sell, but if you have a loss, you tend to wait. After all, you didn’t invest in the market to lose money. However, what you should be doing is selling your worst-performing stock first. Keep your flower patch free of weeds.

You may decide to sell your shares in Myriad Genetics, for example, because it shows a nice profit, but you’ll keep your General Electric because it still has a ways to go before it’s back to the price you paid for it. If this is the way you think, you’re suffering from the “price-paid bias” that afflicts 95% of all investors.

Suppose you bought a stock two years ago at $30, and it’s now worth $34. Most investors would sell it because they have a profit. But what does the price you paid two years ago have to do with what the stock is worth now? And what does it have to do with whether you should hold or sell the stock? The key is the relative performance of this stock versus others you either own or could potentially own.

Analyzing Your Activities

To help you avoid the price-paid bias, particularly if you are a longer-term investor, I suggest you use a different method of analyzing your results. At the end of each month or quarter, compute the percentage change in the price of each stock from the last date you did this type of analysis. Now list your investments in order of their relative price performance since your previous evaluation period. Let’s say Caterpillar is down 6%, ITT is up 10%, and General Electric is down 10%. Your list would start with ITT on top, then Caterpillar, then GE. At the end of the next month or quarter, do the same thing. After a few reviews, you will easily recognize the stocks that are not doing well. They’ll be at the bottom of the list; those that did best will be at or near the top.

This method isn’t foolproof, but it does force you to focus your attention not on what you paid for your stocks, but on the relative performance of your investments in the market. It will help you maintain a clearer perspective. Of course, you have to keep records of your costs for tax reasons, but you should use this more realistic method in the longer-term management of your portfolio. Doing this more often than once a quarter can only help you. Eliminating the price-paid bias can be profitable and rewarding.

Any time you make a commitment to a security, you should also determine the potential profit and possible loss. This is only logical. You wouldn’t buy a stock if there were a potential profit of 20% and a potential loss of 80%, would you? But if you don’t try to define these factors and operate by well-thought-out rules, how do you know this isn’t the situation when you make your stock purchase? Do you have specific selling rules you’ve written down and follow, or are you flying blind?

I suggest you write down the price at which you expect to sell if you have a loss (8% or less below your purchase price) along with the expected profit potential of all the securities you purchase. For instance, you might consider selling your growth stock when its P/E ratio increases 100% or more from the time the stock originally began its big move out of its initial base pattern.

If you write these numbers down, you’ll more easily see when the stock has reached one of these levels.

It’s bad business to base your sell decisions on your cost and hold stocks down in price simply because you can’t accept the fact you made an imprudent selection and lost money. In fact, you’re making the exact opposite decisions from those you would make if you were running your own business.

The Red Dress Story

Investing in the stock market is really no different from running your own business. Investing is a business and should be operated as such. Assume that you own a small store selling women’s clothing. You’ve bought and stocked women’s dresses in three colors: yellow, green, and red. The red dresses go quickly, half the green ones sell, and the yellows don’t sell at all.

What do you do about it? Do you go to your buyer and say, “The red dresses are all sold out. The yellow ones don’t seem to have any demand, but I still think they’re good. Besides, yellow is my favorite color, so let’s buy some more of them anyway”?

Certainly not!

The clever merchandiser who survives in the retail business looks at this predicament objectively and says, “We sure made a mistake. We’d better get rid of the yellow dresses. Let’s have a sale. Mark them down 10%. If they don’t sell at that price, mark them down 20%. Let’s get our money out of those ‘old dogs’ no one wants, and put it into more of the hot-moving red dresses that are in demand.” This is common sense in any retail business. Do you do this with your investments? Why not?

Everyone makes buying errors. The buyers for department stores are pros, but even they make mistakes. If you do slip up, recognize it, sell, and go on to the next thing. You don’t have to be correct on all your investment decisions to make a good net profit.

Now you know the real secret to reducing your risk and selecting the best stocks: stop counting your turkeys and get rid of your yellow dresses!

Are You a Speculator or an Investor?

There are two often-misunderstood words that are used to describe the kinds of people who participate in the stock market: speculator and investor. When you think of the word speculator, you might think of someone who takes big risks, gambling on the future success of a stock. Conversely, when you think of the word investor, you might think of someone who approaches the stock market in a sensible and rational manner. According to these conventional definitions, you may think it’s smarter to be an investor.

Baruch, however, defined speculator as follows: “The word speculator comes from the Latin ‘speculari,’ which means to spy and observe. A speculator, therefore, is a person who observes and acts before [the future] occurs.” This is precisely what you should be doing: watching the market and individual stocks to determine what they’re doing now, and then acting on that information.

Jesse Livermore, another stock market legend, defined investor this way: “Investors are the big gamblers. They make a bet, stay with it, and if it goes wrong, they lose it all.” After reading this far, you should already know this is not the proper way to invest. There’s no such thing as a long-term investment once a stock drops into the loss column and you’re down 8% below your cost.

These definitions are a bit different from those you’ll read in Webster’s Dictionary, but they are far more accurate. Keep in mind that Baruch and Livermore at many times made millions of dollars in the stock market. I’m not sure about lexicographers.

One of my goals is to get you to question many of the faulty investment ideas, beliefs, and methods that you’ve heard about or used in the past. One of these is the very notion of what it means to invest. It’s unbelievable how much erroneous information about the stock market, how it works, and how to succeed at it is out there. Learn to objectively analyze all the relevant facts about a stock and about how the market is behaving. Stop listening to and being influenced by friends, associates, and the continuous array of experts’ personal opinions on daily TV shows.

For Safety, Why Not Diversify Widely?

Wide diversification is a substitute for lack of knowledge. It sounds good, and it’s what most people advise. But in a bad bear market, almost all of your stocks will go down, and you could lose 50% percent or more in some stocks that will never come back. So diversification is a poor substitute for a sound defensive plan with rules to protect your account. Also, if you have 20 or 30 stocks and you sell 3 or 4, it won’t help you when you lose heavily on the rest.

“I’m Not Worried; I’m a Long-Term Investor, and I’m Still Getting My Dividends”

It’s also risky and probably foolish to say to yourself, “I’m not worried about my stocks being down because they are good stocks, and I’m still getting my dividends.” Good stocks bought at the wrong time can go down as much as poor stocks, and it’s possible they might not be such good stocks in the first place. It may just be your personal opinion they’re good.

Furthermore, if a stock is down 35% in value, isn’t it rather absurd to say you’re all right because you are getting a 4% dividend yield? A 35% loss plus a 4% income gain equals a whopping 31% net loss.

To be a successful investor, you must face facts and stop rationalizing and hoping. No one emotionally wants to take losses, but to increase your chances of success in the stock market, you have to do many things you don’t want to do. Develop precise rules and hard-nosed selling disciplines, and you’ll gain a major advantage. You can do this.

Never Lose Your Confidence

There’s one last critical reason for you to take losses before they have a chance to really hurt you: never lose your courage to make decisions in the future. If you don’t sell to cut your losses when you begin to get into trouble, you can easily lose the confidence you’ll need to make buy and sell decisions in the future. Or, far worse, you can get so discouraged that you finally throw in the towel and get out of the market, never realizing what you did wrong, never correcting your faulty procedures, and giving up all the future potential the stock market—one of the most outstanding opportunities in America—has to offer.

Wall Street is human nature on daily display. Buying and selling stocks properly and making a net profit are always a complicated affair. Human nature being what it is, 90% of people in the stock market—professionals and amateurs alike—simply haven’t done much homework. They haven’t really studied to learn whether what they’re doing is right or wrong. They haven’t studied in enough detail what makes a successful stock go up and down. Luck has nothing to do with it, and it’s not a total mystery. And it certainly isn’t a “random walk” or an efficient market, as some inexperienced university professors formerly believed.

It takes some work to become really good at stock selection, and still more to know how and when to sell. Selling a stock correctly is a tougher job and the one that is least understood by everyone. To do it right, you need a plan to cut losses and the discipline to do this quickly without wavering.

Forget your ego, swallow your pride, stop trying to argue with the market, and don’t get emotionally attached to any stock that’s losing you money. Remember: there are no good stocks; they’re all bad . . . unless they go up in price. Learn from the 2000 and 2008 experience. Those who followed our selling rules protected their capital and nailed down gains. Those who did not have or follow any selling rules got hurt.