Ask Matt: Why the 10% rule is important
Q: Why is the 10% rule so important for investors?
A: If you're buying individual stocks — and don't know about the 10% rule — you're asking for trouble. It's the one rough adage investors who survive bear markets know about.
The rule is very simple. If you own an individual stock that falls 10% or more from what you paid, you sell. Period. You don't rationalize the loss and wait for the "good stock" to "come back." Investors who dabble with individual stocks understand that getting back to even following a loss greater than 10% is a difficult task.
Take this example. Say you paid $50 for a share of a stock that rises to $60. If the stock drops to $45 a share, you should be out. End of story. There's a mathematical reason for this. The percentage gains needed to recover from a big loss quickly balloon. Going back to the example of the stock that started at $50 a share and dropped to $45. Just to break even — and get back to $50 — the stock needs to rise 11.1%. Let's say instead of selling at a 10% loss, you wait until the stock falls to $40 a share, for a 20% loss before selling. That means, the stock needs to jump 25% just for you to break even. And to recover from a 30% decline to $35 a share in this example, you'll need a 43% rally.
The 10% rule could become even more important if the market continues to drop. Savvy investors know it's just as important to know when to sell a stock as it is when to buy it.
Remember, though, the 10% rule applies only to individual stocks, which are mostly riskier than the market. If you're a long-term investor with a diversified portfolio, academic studies have shown it's much better to ride out the volatility. There are also more complicated ways to hedge against big losses by using derivatives such as options. But for a rule of thumb, the 10% rule is a great guide.
USA TODAY markets reporter Matt Krantz answers a different reader question every weekday. To submit a question, e-mail Matt at mkrantz@usatoday.com or on Twitter @mattkrantz.