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Cutting Losses Short Prevents Massive Damage To A Portfolio

A lot of work goes into researching a stock. Mix in a little fundamental and technical analysis and, with a lot of practice, you'll get very good very fast at buying the right stocks at the right time.

But very few investors have a game plan when a new buy goes wrong. The reality is that failure to act can result in big losses for a portfolio. And big losses can take months, if not years, to overcome.

Indeed, sometimes it's just as gratifying selling a stock at the right time as it is buying at the right time. Buy a stock at 50, sell it at 46 and six months later, it's at 30. That's a good feeling, even if it was an unprofitable trade.

One of the easiest — and smartest — rules to follow is to always cut losses at 7% to 8% below your purchase price, if not sooner.

Consider it an insurance policy, a way to manage risk in the market. The rule isn't arbitrary. Research into the most successful stocks has found that market winners rarely fall more than 8% from their proper buy points.

This is especially true in the early stages of a new market uptrend, when stocks are coming out of fresh bases thanks to new institutional money coming in from the sidelines.

There are times, however, when a market uptrend will come under pressure due to increasing distribution days — higher-volume declines in the major averages. Buying stocks is OK in a market that's under mild distribution, but there's also nothing wrong with keeping new buys on an even tighter leash. When the overall market is starting to look a bit unsettled, cutting losses at 3% to 4% is a sound strategy.

United Rentals (URI) tried to clear a on April 11, but its action immediately after the was abnormal. On the breakout day, it finished near its low after early strength, a sign of slack buying demand. It lost 8% over the next two sessions.

Was it a big surprise that this breakout didn't work and triggered the 8% sell rule? Not really, because it tried to break out at a time when overall market health was in question. At the time, the Nasdaq and S&P 500 showed six distribution days.

Remember Apple (AAPL) when it cleared a cup-with-handle base in August with a 619.97 ? It did well for a while, rallying 14% to a high of 705 before big sellers came into the stock in October.

After three straight weekly declines in above-average during the weeks ended Sept. 28, Oct. 5 and Oct. 12 — clearly signs of institutional selling — investors had good reason to lock in profits.

Apple eventually triggered the 7%-8% sell rule on Nov. 2 when it hit 575 1. Disciplined investors who didn't sell quickly and accept a small gain or break even took their medicine and cut losses short. Those sitting on a loss are holding and hoping the stock goes back up, but that's a dangerous game to play.