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The first thing to know about investing is when to cut your losses

If you’re in a losing trade, and you find yourself hoping and praying that things will turn around, you are not doing it right. Hope is not a strategy.

Instead, if you own a stock that’s losing money, you should sell it. Cut your losses and move on. Now, obviously you need to have some tolerance for loss—you don’t have to sell if the stock dips 1%. But if it falls by 20% or more, you should probably sell it.

There are a few reasons for this…

Number one: Stocks trend. If they’re going up, they tend to keep going up. If they’re going down, they tend to keep going down.

The reality of the stock market is, turnarounds are rare. Everyone loves to root for the underdog. And that’s fine when you’re watching sports. But with stocks, you want to root for the favorite… you want to root for the Yankees.

Reason number two: A losing stock is tying up capital—both your financial capital and your emotional capital. Your money is locked up in a losing investment, and you’re spending a bunch of time checking your brokerage account, wondering whether the stock will recover.

Remember, one of my main goals here at Jared Dillian Money is to eliminate your financial stress. You will feel better if you sell the loser and move on to other opportunities.

Reason number three: Human beings are hardwired to let losses run.

See, people love to take profits. If you buy a stock and it shoots up 20%, you’re more than happy to sell it and take the profits, even though that’s the worst thing you can do (more on that shortly).

However, if you buy a stock and it drops 20%, your brain will tell you to hang on and hang on. It’s not uncommon for people who think this way to ride a stock all the way to zero.

Do not be one of these people! You have to surrender and accept defeat. That is how you keep losses small.

The Secret to Big Gains

The only thing worse than letting your losers run is capping your winners. This is the surest way to become a bad investor. Like I said, people love to take profits. But remember, stocks trend—they go up over time.

The way to take big gains is to add to your winning positions. This is the hardest thing in the world to do—it just feels unnatural, but I encourage you to give it a try.

Buy a starter position in a stock, and if it goes up, buy a little more. Then, if it continues to go up, buy even more—and let it run.

This is the secret to investing: Do more of what is working and less of what of is not.

Fun Money

Keep in mind, this guidance does not apply to your long-term investments, like your 401(k), IRA or other retirement accounts. That money should be in safe things, like The Awesome Portfolio, with a mix of stocks, bonds, cash, gold, and real estate.

For these accounts, you want to buy on the way up… buy on the way down… buy all the time. This is called “dollar-cost averaging,” and it’s the best way to invest for the long term.

When you know that 90% of your money is squared away in something solid like The Awesome Portfolio, you are free to speculate with the rest.

And that is what the guidance we just covered, about selling the losers and adding to the winners, is for—your “fun” account. Everyone should have one of these—just please remember to cap it at 10% of your investable assets. (Seriously, do not speculate with money you cannot afford to lose.)

Chances are you won’t make much money. But who knows? Maybe you’ll shoot the moon.

Jared Dillian