by Dave Coker

Created on: June 25, 2008

So you heard the rumor or read some news and you bought yourself some shares! Good for you. We invest our money to make more money and, after all, stocks go up don't they?

They certainly do. But stocks also go down. Then they go up. In fact, sometimes the price of shares varies wildly, and a winner, a share that has sharply increased in value suddenly becomes a loser, rapidly dropping in price. Should we sell or hold onto an asset that is declining in value? What is the risk of holding onto dropping shares?

A SIMPLE EXAMPLE

Good questions, and let's work towards an answer with a simple example.

Assume you purchase a single share of TheBigCompany for $10. We assume a single share just to make this example clear, but the same principles will apply if we're talking about one share or one thousand shares.

The next day, in response to bad news, the price of TheBigCompany suddenly drops to $5 a share. In other words, before you could do anything you've got a significant loss - in fact a loss of 50%. Hardly encouraging.

At this point there are two options available: sell the stock or hold onto the stock. Let's work through both alternatives and see what happens.

SELL

You bought your single share of stock for $10 and you sold it $5. You've got what's known as a "short term capital loss", and this loss can be reflected on your tax return as an adjustment to gross income. The deduction is limited to $3,000 per year, but if you are unlucky enough lose more than that in a single year you can carry the balance forward every year until fully utilized.

Not the best outcome, but at least we can use some of the loss to shield other profits. But this is hardly a way to invest, to use your money to make more money.

HOLD

Some people, when presented with such a choice of taking a 5$ loss will hold onto their losing shares. After all, you're not really losing money until you sell. So in this example, we purchased our single share of stock for $10 but the price dropped without warning to $5.

We've got a "paper loss" of 50%. Now for a trick question - how much, in percentage terms, does must this stock increase in value for us to reach break even? In other words, what is the percentage increase that we must realize to see this share trade at $10 again.

Hope you didn't answer 50%!

Actually, the your share must now increase in value 100%. Think about it - $5 times 100% is $10 . Only if this share doubles in price, increases by 100%, do we reach break even.

Now considering the long run rate of return of the stock market is about 7% per year, does a 100% increase in a stock - that has already FALLEN 50% - sound possible?

Of course anything can happen, but how probable is this increase?

Not very.

CONCLUSION

When selecting the companies we'd like to invest in, we must also specify the maximum loss we'd bear before selling. In other words, when we purchase a company are we willing to tolerate a 5% decline in price? Or are the shares typically more volatile, and we believe the price can decline some 20% in value before once again rising?

Good investors can tolerate some loss; after all, nobody expects to win all of the time. Loss is all part of the stock market game. But good investors get into trouble when they don't think about their maximum loss, in other words, they didn't plan.

Therefore we need to specify, before purchasing, the price at which we would sell these shares if they were to suddenly decline in value.

If we don't specify this price, then the risk of holding onto dropping shares is the unplanned loss of significant amounts of our capital.

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