You're at your annual holiday party. A fellow reveler says he's not concerned about the recent market volatility because he's a "buy-and-hold" investor. Now, I don't want you to start any trouble, but you might politely remind him of two letters: G and E, as in General Electric (NYSE: GE).
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I know I sound like the proverbial broken record when I talk about this topic, but the fact of the matter is that I worry more about the risks investors are taking than anything else. It's dismaying to me that many "conservative" investors practice a buy-and-hold approach to themarket, failing to realize the risks of that strategy.
Buying a stock should always involve some consideration of value. Whether it's robust cash flow or even something as simple as a low P/E multiple, it's always important to have an educated guess about what your investment will be worth down the road. Unfortunately, many buy-and-hold investors ignore value, because they are investing for the long-term, come hell or high water.
I literally cringe when I hear about someone losing money in the market because of either misunderstood philosophies, a nonchalant attitude, or simply ignoring the risks they are taking.
But don't get me wrong. As much as I bash buy-and-hold investing, it can work... if you follow some simple rules. You still have to have a sell signal in place to preserve capital. The market doesn't care how fantastic your stocks are. If you blindly believe that in the long run your favorite stock will appreciate, let me repeat those two letters: G and E. Let's see how that turned out for investors who bought GE back in 1996 and held on for the ride...
That's right... after 23 years the stock has gone exactly nowhere. And we're not talking about some fly-by-night company here. We are talking about the firm founded by the likes of Thomas Edison and J.P. Morgan in 1892. A company that generated $120.4 billion in sales last year.
Sure, there were times investors could have hopped off the GE train and booked a tidy profit, but I'd bet that those who did are few and far between. That's mainly because investment decisions are usually controlled by emotion, not logic (where is Mr. Spock when we need him!?). It's usually only when you're out of a position that you see things in technicolor.
You'll likely hear plenty of commentators talk about how "this is the bottom" for GE. And maybe they're right. But they also said the same thing this spring after shares tumbled from around $18 to down around $12, a 30% haircut -- only to watch shares continue to drift to less than $7 a share.
Followers of the buy-and-hold strategy are accepting astronomical risks without realizing they are doing so. In this case, they lost the most valuable -- and irreplaceable -- thing when it comes to investing and building wealth. That's time. These investors seem to accept these risks -- the risk of losing 23 years of time -- with nothing to show for it.
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Imagine if these "buy-and-hold" investors had followed a simple 25% trailing stop-loss strategy. From January 1996 until GE's first 25%-plus pullback in October 1998, they would have locked in a triple-digit return... and avoided the dot-com bubble.
The reason I talk so much about risk management and cutting losers short is that I know how hard that can be. It's tough to sell a stock for a loss. Most traders would rather hold onto a loser than admit they are wrong (which is what you are doing when you cut a loser). The thinking is always, "I'll get out when I'm back to even."
Your pride and ego take a hit when you sell a loser. But you have to get that sort of thinking out of your head if you want to be successful in the stock market. Once you realize that making money is more important than your pride or ego, you will be on your way to becoming a more successful investor.
Don't let small losers turn into big losers. Learn to accept -- and feel OK about -- cutting a loser from your portfolio. Because it's not a loss... it's a victory against avoiding a massive loss.
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This article originally appeared on StreetAuthority.com.