How to Deal With Losses in the Stock Market

You can mitigate the sting with the right mindset

Frustrated Investor on Telephone
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Cultura

There's no way around it: If you invest in stocks, at some point, you're most likely going to lose money. Sometimes, the loss is immediate and clear, as is the case when a stock you bought at a higher price has plummeted. In other cases, your losses aren’t as apparent because they’re more subtle and take place over a longer period of time.

Losses in the stock market come in different forms, and each of these types of losses can be painful, but you can mitigate the sting with the right mindset and a willingness to learn from the situation.

Capital Loss

This form of loss is the simplest and perhaps most painful: You buy a stock and then watch the price go down and stay down. At some point, you decide to end the pain and sell it. This kind of loss is called a capital loss because the price at which you sold a capital asset was less than the cost of purchasing it.

You can use a capital loss to offset a profit from selling a capital asset, which is known as a capital gain, for tax purposes. A capital loss (or gain) is characterized as short-term if you owned the asset for one year or less. If you owned the asset for more than one year, the loss is considered to be long-term.

Opportunity Loss

Another type of loss is somewhat less painful and harder to quantify, but still very real. For example, you might have bought $10,000 of a hot growth stock, and one year later, after some ups and downs, the stock is very close to what you paid for it.

You might be tempted to tell yourself "Well, at least I didn’t lose anything." But that's not true. You tied up $10,000 of your money for a year and you received nothing in return. If you had stashed your money elsewhere, such as in a certificate of deposit (CD) instead, you would have earned at least a little bit of interest during that same year. This is known as the opportunity loss or opportunity cost.

Every stock purchase begins with a measurement against a lower-risk investment, such as a U.S. Treasury note. Ask yourself whether the potential gain from purchasing a particular stock is worth the additional risk.

When a stock goes nowhere or doesn’t even match the lower-risk return of a bond, you've experienced an opportunity loss—the chance to have made more money by putting your money in a different investment. It's basically a trade-off that caused you to lose out on the other opportunity.

Missed Profit Loss

This type of loss results when you watch a stock make a significant run-up and then fall back, something that can easily happen with more volatile stocks. Not many people are successful at calling the top or bottom of a market or an individual stock. You might feel that the money you could have made is lost money—money you would have had if you had just sold at the top.

Many investors sit tight and hope the stock will recover and regain the high, but that might never happen. And if it does, some investors may be tempted to hold on again, hoping for even greater profits, only to see the stock stage another retreat. The best cure for this type of loss is to have an exit strategy in place—and to be happy with a reasonable profit.

Don’t try to squeeze every penny out of a stock by timing the market. You’ll risk the possibility of a retreat and a missed profit loss.

Paper Loss

You can tell yourself that “if I don’t sell, I haven’t lost anything,” or "your loss is only a paper loss." While it's only a loss on paper and not in your pocket (yet), the reality is that if your investment in a stock has taken a major hit, you should decide what to do about it.

If you believe the company’s long-term prospects are still good and you're a value investor, it might be a fine time to add to your holdings. On the other hand, your paper loss will become an opportunity loss if the stock continues to underperform.

How to Deal With Your Losses

No one wants to suffer a loss of any kind. However, you shouldn't let your ego get in the way of making the right decision when it happens. The best course of action is often to cut your losses and move on to the next trade.

After you've taken a loss in the market, turn it into a learning experience that can help you going forward.

  • Analyze your choices: Review the decisions you made with new eyes after some time has passed. What would you have done differently in hindsight and why? If you had acted differently, would you have lost less or perhaps nothing at all? Answering those questions may help you avoid making the same mistake twice.
  • Recoup what you lost: Tighten your financial belt for a while if you must and if the loss is small enough, you may be able to recoup it with a little discipline. Regain that money and then try again, keeping in mind the things you learned for the next time the market gets shaky.
  • Don’t let losses define you: Keep the loss in context and don't take it personally. Remind yourself that a lot of other people out there took a hit just like you did—perhaps even more of a hit than you did. The loss doesn't define you, but it can make you a better investor if you handle it correctly.

The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.

Article Sources

  1. IRS. "Topic No. 409 Capital Gains and Losses." Accessed May 6, 2020.