1. Money

How to Deal with Losses in the Stock Market

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You are going to lose money if you invest in stocks. Sooner or later, it’s bound to happen. If fact, it may have happened already and you don’t recognize it because losses can take several different forms.

In its simplest and perhaps most painful form, you buy a stock then watch the price go down and stay down. At some point, you decide to end the pain and sell. (See Knowing When to Sell a two-part series on understanding when the best time to sell a stock.)

This type of loss, which involves an actual dollar amount, is called a capital loss. You can use a capital loss to offset profits (capital gains) for tax purposes. Beyond that, they aren’t worth much other than a painful investing lesson.

Lost Opportunity

There’s another type of loss that is less painful, but very real. Say you bought $10,000 worth of a hot growth stock. One year later, after some ups and downs, the stock is very close to what you paid for it.

You might be tempted to tell yourself, ‘Well, at least I didn’t lose anything.’

Not true. You tied up $10,000 of your money for a year and received nothing in return. If you had bought a bank CD, you would have at least earned a little interest.

Every stock purchase begins with a measurement against a risk-free investment such as a U.S. Treasury Note. Knowing you could earn that return with no risk, how much more can you earn with some additional risk in purchasing a particular stock.

When a stock goes nowhere or doesn’t even match the risk-free return of a bond, you are losing money.

What you lost was the opportunity to invest your money is something that would have earned you a positive return over and above the risk-free return - and that is a true loss.

Missed Profit Loss

This loss results when you watch a stock make a significant run up and then fall back, which may happen with volatile stocks. Few people are successful at calling the top (or bottom) of a market or a stock. You may feel that the money you could have made had you sold at the top is lost money.

Many investors will sit tight and hope the stock will “recover” and regain the high.

The problem is that may never happen and, even if it does, too many investors hold on hoping for even greater profits only to see the stock retreat again.

The best cure for this type of loss is to be happy with a reasonable profit and don’t try to squeeze every penny out of a stock risking a retreat and a “missed profit loss.”

Paper Loss

“It’s only a paper loss.”

“If I don’t sell, I haven’t lost anything.”

You can tell yourself whatever fibs you want, but reality is the only way out of an investing mess. If you made a mistake or something unforeseen happened and you own a stock at loss, you need to decide what to do.

If you believe the company’s long-term prospects are still good, it may be a good time to add to your holdings.

On the other hand, if you believe this is where the stock is going to stay, then your paper loss is becoming a lost opportunity and every day you sit on your paper loss is a day you could have invested your money in something that is earning you a profit.

Conclusion

No one wants a loss, but if it happens, don’t let your ego get in the way of making the right decision. Most of the time, the best course of action is to cut your losses and move on to the next deal.

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