Why You Must Limit Losses

Last Updated: 14. November 2023By

Let profits run and limit losses. That is the basic principle of trend following. Last week, we already dealt with the profit side. Today it is about the case that a position runs into the red.

This is one of the most difficult decisions an investor has to make: when do I limit the loss? Psychological factors also play a role here:

Realizing a loss is the admission that a wrong decision was made when buying. Many investors find this difficult.

Often an investor then hopes that an unrealized loss will eventually turn into a profit or at least balance out. „If the position is at least back to zero, I’ll sell it,“ is often said.

Those who do not limit losses risk destroying their trading account. Limiting losses is crucial to success on the stock exchange. Those who do not limit losses risk destroying their trading capital and in the worst case their trading account.

But how much loss should one allow a position? This depends strongly on the investment horizon. Those who trade short term must limit losses very early. William O’Neill, one of the founding fathers of trend following, for example, recommended a maximum loss of 7% per position. However, he only traded with an investment horizon of a few weeks.

Those who invest for the long term usually have a position that is particularly well chosen. They have looked at the fundamental valuation, news situation and growth prospects of the company and are convinced that it will continue to grow in the coming years. In this scenario, one can in my opinion also bear greater fluctuations if the position does not take off immediately as hoped.

At some point, however, you have to admit that your analyses were wrong and that you have to sell a share. Personally, I pull the ripcord at the latest at 30 to 35% loss in such a scenario.

How can a loss be best offset? Make sure of this: If you have a loss position in your portfolio, it is of course your wish to offset the loss as quickly as possible.

But ask yourself this question: Is the share that caused the loss really the best way to get back to zero at least? Nobody can guarantee that a share that has already lost 50% will not lose another 50%.

Or wouldn’t it be much more sensible to sell the share at a loss and invest the remaining capital in another share that is much stronger and can offset the loss more quickly?

That is why my tip: Do not be afraid of realizing losses. Limiting losses is an important means of protecting your capital and staying actionable.