Always Cut Your Losses Quickly

05/11/2011 3:00 pm EST

Focus: STOCKS

Gil Morales

Managing Director and Chief Portfolio Manager, MoKa Investors, LLC

A cardinal sin of most investors is staying in losing positions for too long, says portfolio manager Gil Morales. Learn to identify the signals early, and then get out!

In both trading and investing, psychology and the attitude of people toward the markets has a lot to do with success. Our guest today is Gil Morales to talk about that. 

So Gil, what kind of mistakes or pitfalls do people have psychologically about their investments?

I think investors trip themselves up from the outset by taking the basic attitude that once they buy a stock, they've married it. They don’t take advantage of the fact that the markets are very liquid and when they make a mistake, that can be corrected very quickly by selling the stock that they own.

Also investors don't allow themselves to be wrong. They buy a stock with the idea that they have to be right or they're going to follow that thing all the way down to nothing, in some cases. 

So really investors need to allow themselves to make mistakes and then be willing to use the liquidity of the market.

In other words, the fact that you can buy and sell something all day long to correct your mistake. Also, Bernard Baruch said that it wasn’t really a matter of being right—how many times you were right in terms of picking stocks—but how you handled the stock once you knew you had a winner on your hands.

I know for myself it's not just a matter of sometimes taking a losing position and getting rid of it and acknowledging the loss, but missing a trade or missing a good investment that I hear has gone up and I thought I should've taken at that time. What can I do about that idea?

Well I think understanding buy points in stocks, and in the book that we wrote, Trade Like an O'Neil Disciple, we talk about buy points and where investors can find buy points within uptrends, within consolidations. 

So investors should understand what proper buy points in a stock’s chart pattern are and when they do miss a stock initially, a stock will always give them a second chance to buy it if they understand when and where to buy the stock.

Another thing is the risk of it all. How do I know psychologically…that I hear that I'm only supposed to take trades that I'm comfortable with the risk. How do I gauge that for myself?

Well if you can't sleep at night, then you probably have no business investing in stocks. 

But I think all investors when they buy a stock should have a basic stop/loss point in mind. Wherever they buy the stock, they should decide, do they want to risk 7% of the capital that they put into the stock, 10%, 15%?

Jesse Livermore used to use 10%; William O'Neil, who's my mentor, has advocated 7% to 8%. I use that. I might also like to keep it tighter, if I think I can, to 3% to 5%. 

You should always have an “out” point because the market is essentially a feedback system.
 
So when you buy a stock and it starts going down, the market is telling you de facto that your decision was wrong. So you have to have a mechanism for accepting the market's feedback and then using it to your own advantage.

How about the market itself? I hear that I need to find a market that fits my personality or fits my risk tolerance. What about that idea?

Well I think investors should school themselves in recognizing when the market is in an uptrend and when it is in a downtrend.

(If) we're starting a new bull market, that's the best time to be buying stocks during a bull market, and during a bear market, you want to be backing away and going to cash. 

Investors should be willing to take profits and back away to cash and protect themselves when they're able to discern when a bear market is starting.

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