Cramer on When to Cut Your Losses

When do you cut your losses? When do you run instead of average down?

These two questions occupy a tremendous number of our readers. I probably get four or five emails a day from people asking me what I would do in a losing situation.

Most of them I can't comment on because they involve advice on specific securities that I won't give. But they do all fall into a couple of patterns, general patterns that I can comment on.

First, there are no hard and fast rules. I have known great investors who literally sell down 15% no matter what, and then rebuild the position if they find that things are okay. I also know people who don't even acknowledge the fact that they are down on a stock, as if a buy of a $50 stock that goes to $40 just means that you are early, or that $10 doesn't count as being down.

I am not in that camp.

When I traded with my wife, she always drew a distinction between a trade and an investment. I have stuck with the rules of the Trading Goddess ever since, so let me share those with you.

First, if you buy a stock for a trade off an event or a piece of news, and the catalyst occurs, you have to sell whether you are up or down. That's called discipline, and as it says on my ILX workstation: "Discipline is more important than conviction."

If something is put on for a trade and a trade only, Karen would always, always blow it out down a dollar. The thinking was that the gains would always occur, but if you don't cut your losses you will always lose.

That's right and inviolate, so I stick by that rule.

But investing: Well, that is different. When I invest, I do so after a massive amount of homework. The starting point of that homework is that if the story is a good one, it only gets better as it goes lower. Any decline, particularly a decline caused by a market selloff, is a godsend.

That does not mean you can be complacent. If a stock goes down repeatedly, I re-examine my thesis constantly. I want to be sure that the reasons I bought a stock are still intact.

Let's say I want to take a big stake in National Giftwrap and Box Company because I think it is undervalued. The firm has a huge inventory of unsold giftwrap rolls priced at about $60 that have skyrocketed in value to $400 because of a shortage of makers of fine papers brought on by incessant mergers in the industry. I also like the new foldlock top box that National has, thinking it's got the competition beat. (Stop salivating, this is my Dad's company and it is not for sale.)

Now, for two consecutive days sellers have pummeled the stock. I will check my sources in the industry and check with the investor relations person to see if some near-term outlook had changed. I will call all of the analysts on the stock to make sure nothing is wrong or nobody has downgraded it.

If nothing has changed, or if I don't respect the downgrade, I will simply use the weakness to buy more on a scale. I will continue to do so until I have so much that I want to wait until buying more will really help my average. If the story is still intact, I will never sell it unless some extenuating circumstance causes me to sell.

I do not write this to make you complacent about your unrealized losses. Stories and fundamentals do change; I take losses all of the time on investments that go bad. But if they haven't gone bad, I don't take them. I wait until my thesis comes to fruition. And I generate trading gains to offset the lag between when I place my bets and when I reap my profits.

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