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Sunday, 20 September 2009

Investor's Corner: Cut Your Losses, But Ride Out Your Gains

Joanne Von Alroth

Nobody's right all the time. (Except, maybe, mothers. But that's a different story.)

With the right investment strategy, though, you can be right less than half the time when you pick stocks and still come out ahead.

Sounds too good to be true? It's no snake oil. Just simple math.

If you cut your losses at 7% or 8%, and let your winners run so you can take profits at 20% to 25%, you'll keep your portfolio ahead.

Cutting losses short is a rule often repeated in IBD. But that's because it's one of the most difficult to stick to. And because it works.

Why? Because investors tend to get all emotional about their stocks -- they get attached and think, "It has to get better," and then they don't sell the laggards until they've already lost a load of cash.

Cutting your losses is the absolutely best defensive strategy when it comes to managing your stocks. When a stock starts losing money, it's usually just a bit here and there. That's exactly the best time to deal with it -- before it can really do some damage to your portfolio.

When you see your stock fall 7% from your purchase price, the warning bells should be ringing. Dump that puppy now, and you only have to make 7.7% back to be even.

But guess what? Stick with that stock until it falls 25%, and it's going to mean that you have to see a 33% rebound before you get back to even. If you miss a sell signal, and you lose 50%, you have to notch a 100% rebound before you hit the break-even point.

So, if you buy a stock at 50 a share and it falls to 46, lose it like a bad prom date. Do not pass go, do not collect anything -- just get rid of it. Employ your discipline.

If it turns out that the stock regains its previous glowing stature right after you divest, don't sweat it. Be glad you can be disciplined.

If the stock sets up in a proper buy point again, you can always buy it back. If not, you're safe and ready to invest again, with most of your capital intact.

But what if your stock isn't tanking, and instead is running up? You don't want to sell yourself short, literally.

If a stock shows no sell signals, you could try to hold it for a profit of 20% to 25%. Why this target?

IBD founder and Chairman William O'Neil found through his research that "successful stocks, after breaking out of a proper base, tend to move up 20% to 25%."

"Then they usually decline, build new bases, and in some cases resume their advances," he wrote in "How to Make Money in Stocks."

If you're trying to decide whether to go for a huge gain on a current leader, look at its action. Did the stock gain 20% or more from a breakout within three weeks? If so, it might be a big winner. Try to hold such stocks for at least eight weeks.

Look at the firm's fundamentals. Leading stocks show outstanding quarterly growth because the firm has an innovative product or service. They also tend to be newer issues that went public within the past eight years.

Brazilian steel products maker Companhia Siderurgica Nacional (NYSE:SID - News) is a good example of a stock that makes a fast rise from a breakout.

It broke out of a cup without handle the week of Sept. 14, 2007 (point 1). The base started in July.

The company had strong fundamentals, with second-quarter earnings growth hitting triple digits. It ran up 20% within three weeks after its breakout (point 2). It topped at 52.46 the week of May 23, 2008, for a 161% profit.

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