Why is it Important to Limit Losses?

in Loss

Limiting losses when investing is very important as the increase needed to recover the loss grows exponentially as the loss gets larger.

A 10% loss for example requires an 11.1% recovery in the share price to break even again. Similarly, a 50% loss requires a 100% increase to recover as you now will have only half of your original capital.

The following table shows the relationship between a loss and the recovery visually.

Loss   Increase to recover loss

5%   5.3%
15% 17.6%
25% 33.3%
35% 53.8%
45% 81.8%
55%   122.2%
65%   185.7%
75%   300.0%
85% 566.7%
95% 1900.0%

Whatever approach you take to selling, this is the most important principle to bear in mind, irrespective as to how positive you are on the recovery probability of the losing investment in your portfolio.

Another example.

Assume you are targeting a 15% annual gain on your portfolio. You have just invested 1,000 in a share it has dropped, and you sell it at a 25% loss (i.e. you have lost 250).

At the same time you have invested in two other shares at 1,000 each, and have made an average gain of 35% (700) on both of them.

On your total investment of 3,000, you have now made 450 (700 minus 250), which equals a 15% return.

What would have happened if you had held onto your losing stock a bit longer before getting out? For example, if your 1,000 investment drops 50%, you have lost 500. That means you would have to make almost a 50% average return on your two other 1,000 investments to have a 15% return on your total portfolio.

Making a 35% annual gain on stocks can be achieved, but making 50% consistently is, however, a different matter.

But it could be even worse. If you had let your first share drop 75% before selling, you would have had to make 60% on your other two shares just to make a 15% return on your overall investments. While 60% is possible, it's extremely hard to do.

So by letting your losses increase, you have put yourself in a position where you have to make exceptional stock selections just to make average returns.

A further reason why limiting losses, especially large losses, is important.

Losses can cause you to lose confidence in your ability to make investment decisions. This means that not only do you have to consider the current loss, but also the future profits not made, because of your lost confidence. 

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Tim Du Toit has 1 articles online

Tim du Toit is the editor of EuroShareLab. The purpose EuroShareLab is to share knowledge and ideas gained in over 20 years of investing experience and continuous learning to help other self directed investors on their investment journey.

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Why is it Important to Limit Losses?

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This article was published on 2010/04/01