Investing 101: Understanding the Break Even Point

As I discussed in last week's piece on knowing when to give up on a losing stock, the answer is not always as cut and dry as you would think. Understanding what each company does and how their business is structured compared to years past and to its peers is paramount. Yet even when this is known, it is hard for many people to stomach the thought of getting involved with a stock in the first place...which is just plain silly. 

What each investor MUST have is an exit strategy for each and every security they own. (Hmm...I wonder what would have happened if we did this with relationships as well?) It doesn't make the pain easier to take, but you can feel better knowing that you made the right decision to quit after the first red (or even yellow) flag than you would if you waited for 10 obvious flags waving in your face. Here are a couple common questions that are often asked when a stock is collapsing:

Should I just keep holding the stock until it breaks even again?

In some situations, breaking even (where profits cancel out losses for a net gain of zero) can happen, but it is often a lie that investors tell themselves to feel better and to justify hanging onto loser stocks indefinitely. Back in the year 2000, the burst of the tech bubble caught so many investors by surprise that many people were completely unaware of the fact that their portfolios had lost 50-60% of their original value! However, if they had held those same stocks through today, they would be rich. So, the break even theory CAN work, but the amount of time and stress involved are often not something that many investors can live with in the near term.

What about that adage "buy at the bottom"?

The oldest quote about the stock market: "buy low; sell high." If it's used correctly, this can certainly help! Say a stock that you bought declined for an uncontrollable reason (earnings sentiment, weather, terrorism, etc.) yet the long-term fundamentals remain intact and strong. Instead of giving up on the stock, when you understand it to be a long-term growth story, this would be the time to buy MORE shares of the same stock at a lower price. A reversal to the upside in the future could mean that you get to the break even point marginally faster.

Why is it important to cut your losses and not wait to break even?

It is important to understand that there is NO guarantee that any stock will recover its losses, and sometimes waiting for that to happen can really harm your portfolio. This chart created by Investopedia, shows the importance of cutting your losses. The figures in the chart below show by what percentage a stock must rise after a drop just to get it back to break even. 

Many investors often ignore basic math and suffer losses much greater than they realize. Think of it this way: a stock that declines by 50% must return 100% in order to break even. If a stock is $10, then drops to $5 (a 50% loss), that means the stock must return 100% of it's value just to get back to $10. Many investors don't understand that if a stock declines by 50%, it needs far more than that to get back to where it where it was before. 

Lesson? The best offense is a good defense.

Many of us don't have an emergency plan until we NEED to have one, but this is not smart. Just as you prepare for the worst by purchasing life insurance, you need to have an emergency plan for your stocks. We will discuss how to create that plan in a later blog post. Until then, be careful of what breaking even means to you.