If you cannot sustain big short-term losses, there is really no way to ever make money investing.

Markets are Unpredictable and Impossible to Time

The reason why you must sustain losses at first, is because both the Market and Business are entirely unpredictable. Even if you are completely correct right now in your evaluation of a business, unforeseen outside events, and bad luck are always conspiring to turn currently attractive investments into duds.

At the same time, when it comes to the Market, if you’re trying to make money, by definition, you must anticipate the Market. You cannot react to the Market. However, it’s impossible to know when the Market will pile into an investment driving up the price. In other words, despite the fact that your investment thesis is correct, it make take quite awhile for the Market to agree with your view, especially if you are somewhat of a noncomformist, which I consider a prerequisite character trait for any successful investor.

A Recent Example in PWER: Stock Falls 80% After I Recommend It, Only to Rebound 1,000% Thereafter
PWER provides an excellent example of the above investment advice. When I first wrote about PWER back in September 2008, the stock price was around $2. I correctly called attention to the company’s growing inverter business for the renewable energy industry, underlying cash-flow, and to a recent acquisition of a competitor. All three points, suggested that PWER was a solid investment. Nevertheless, despite the fact that I called the fundamentals of the company correctly, the stock price proceeded to plummet 80% after my recommendation, as the financial crisis unfolded.

Amazingly, however, a little over a year later, PWER’s shares have soared to $4.50, and analysts have falling over themselves to upgrade the shares, based on the company’s growing inverter business. Of course, I have no idea how PWER will perform going forward, but I find it fascinating that it took over a year for others to recognize the company’s potential. In case you are wondering, I didn’t have the fortitude to handle the steep decline in PWER’s price after my recommendation and I no longer hold the stock, having sold at a small loss. A combination of “Recency Bias” and Cognitive Dissonance, has kept me from getting back into the shares at much lower prices. Incidentally, my original write up, posited a $6.50 per share price target based on a relative valuation to Xantrex, a Canadian company that was acquired by Schneider Electric.

The Correct Strategy: Sell Winners and Buy Losers
I can provide many more examples like PWER from my investment life, but the important point remains, that if you are investing correctly you need to expect losses, sometimes large ones, before you make money. The key is to understand that if you are investing in situations that have low downside risk and high upside reward, in the long run, good luck will produce a few very big winners. However, in the short run anything can happen and does happen. You need to have deep pockets, patience, and alot of luck.

When you understand the above, it is clear that the advice given in many popular investment books, to cut losses quickly, set stop losses etc., is completely false and mainly sends money to your broker by inducing overtrading. In fact, I’d hazard to recommend that the best investment policy, assuming you’ve done your research carefully, is to sell your winners and double down on your losers. But, again, buying losers will only make sense if you’ve carefully considered all aspects of the company, especially the balance sheet, and you have some intellectual understanding for calculating the risk/reward of investments.