When the market
began its decline in the spring of 2000, many investors
froze like a deer caught in the headlights of an
oncoming car. These individuals are now sitting in
stocks that have declined by as much as 50% to 60%.
Although we sympathize with them, this situation can
only be attributed to a complete lack of discipline.
Whether you are a long-term investor or a short-term
trader, stop losses need to be set and obeyed. Traders
should always remember that there is absolutely no
guarantee that a stock will ever come back. Today’s
big names could easily be forgotten in the next bull
market.
Besides taking the risk that a
stock may not bounce back you are also tying up money
that could potentially be put to work in a different
stock. A perfect example would be investors who sat in
Cisco Systems (CSCO) from January until April of 2001 while the stock went from $40 to $20 per share.
During this exact timeframe BlockBuster Inc. (BBI)
went from $8 to $16, a 100% increase in price.
Many investors don’t realize
that the hole they are digging is much deeper than it
initially appears. They falsely believe that if a
stock is allowed to drop by 20% it will simply have to
come back by that same percentage before returning to
profitability. Unfortunately, the more you let a stock
drop the worse off your situation becomes.
If you told a person that once
they have let a stock drop by 20% the stock will now
have to rise by 25% to get back into the green, they
would probably look at you as if you were crazy. Sadly
this statement is true and is illustrated in the
example shown below.
- Example:
- Let's say you purchased XYZ
Corp. at $100 per share. The stock then started to
go against you and you allowed it to drop to $80
per share, or a 20% drop in price. Now, how much
does an $80 stock have to increase in value to
reach $100?
An $80 stock has to rise in price
by 25% to get back to $100, does it not?
As previously stated, the
further the stock is allowed to drop, the worse this
situation becomes. A 50% drop, for example, would
require a 100% price increase to simply reach the
price at which the stock was originally purchased.
Below is a chart listing the amount of the initial
drop, compared to the distance the stock has to move
to recover its losses.
