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Rules to Avoid Catastrophic Losses

Making money in the stock market is as much about avoiding big losses as it is about scoring big gains. Hereís why.

Say you bought a stock for $100 and ended up selling it for $50, a 50% loss. Next, you invest your remaining $50 in another stock. If your new stock goes up 50%, youíre only up to $75. To get back to even, youíd have to score a 100% gain, which is hard to do. Thatís why avoiding catastrophic losses should be priority number one.

Here are six rules that could help you to do that.

1) Stick with strong stocks
A stockís price action tells you what the market thinks about its outlook. Stocks go up when most players see good times ahead, and down when they donít. Itís tempting to think youíre smarter than the marketóbut youíre not. So, stick with uptrending stocks. Here's how to check that.

A moving average is a stockís average closing price over a specified number of trading days. A stock is in an uptrend when itís trading above its moving average and in a downtrend when trading below. The 50-day moving average is useful for gauging short-term price swings, while the 200-day MA works best for evaluating long-term trends. Yahoo (finance.yahoo.com) lists both in its Key Statistics report. Stick with stocks trading above both their 50- and 200-day moving averages. 

2) Avoid cheap stocks
Sure, we all want to quit our day jobs, and the easiest way to do that is by loading up on a stock selling for pennies a share that soars to $100. But the odds of hitting that home run are about the same as winning the lottery.

Stocks changing hands for less than $5 per share, often termed ďpenny stocks,Ē trade for those prices because most market players see fundamental problems ahead. Donít buy stocks trading below $5.

3) Never average down
Averaging down means buying more shares when one of your stocks is trading below your purchase price. Bad idea! Your stock dropped because something went wrong. Chances are, it will drop even further in the coming weeks.

4) Sell when management cuts sales or earnings forecasts
Your stock will take an instantaneous hit when management lowers future sales and/or earnings forecasts. When that happens, your first instinct will be to hold on to the stock until it recovers. Donít! Your first loss is usually your best loss. More bad news is probably on the way.

5) Sell when a competitor says business is tough
I
f youíre lucky, a competitor will sound the alarm and take the hit before your stock does. When that happens, your company will say that the competitorís problems were company specific and donít apply. Not true! Everybody in the same industry faces the same problems. Take advantage of your good fortune and sell before your company issues similar bad news.

6) Donít be too late to the party
Itís tempting to jump on the bandwagon when your friends are talking about how much money theyíve made on a stock. But, by then, it may be too late. Always check a stockís valuation before you buy. The price/earnings ratio, which compares current share price to the last 12-monthís earnings is the most widely used valuation measure. But, for fast growers, itís better to look ahead than back. Thus, instead of trailing P/E, use Yahooís forward P/E (Yahoo Key Statistics Report), which compares the current share price to the next fiscal yearís earnings to measure valuation. Stick with stocks with forward P/Es below 40, and lower is better.

These rules will help you avoid making catastrophic mistakes that could sink your portfolio. But following them doesnít mean that youíll make money in the market. For that, you still have to do your due diligence. You need to understand your stockís business plan and the overall outlook for its industry. The more that you know about your stocks, the better your results.

3/27/11

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