Avoiding big stock losses requires investor discipline

— -- Q: If I made a bad stock pick in one year, how hard is it to recover in the next?

A: Some bad decisions are easy to recover from, like that extra helping of turkey gravy at dinner last night. But when it comes to stocks, big blunders can be devastating.

Big mistakes picking stocks can be nearly impossible to bounce back from. Why? It's really a mathematical exercise.

Here's an example. If you buy a stock for $100 a share and it falls to $60 a share, that's a bruising 40% loss. Some investors assume a 40% gain would erase that loss. That's not true, unfortunately. A 40% gain would only get you back to $84 a share. To get back to even after a 40% loss, an investor would need a 67% gain.

Climbing back from huge stock losses is extremely difficult due to the harsh reality of math. And that's why investors picking individual stocks need to be extra careful to not allow losses to get so big that they're nearly insurmountable.

The sheer difficulty of coming back from a big loss isn't just theoretical. A study of actual returns by the Standard & Poor's 500 bear out how investors who get hammered with a big loss have such a difficult time coming back.

This poor bad-luck investor, having suffered an average 38% loss in 2010, would need a 61% gain in 2011, just to break even by the end of the year.

How difficult would it be to find stocks with a 61% gain? Well, that was well below the return of the stock market. During 2011, the S&P 500 was dead-flat. That means the prudent approach of investing in a diversified basket of stocks via the S&P 500 wouldn't have cut it. Investors, just hoping to recoup their losses, could have had to take on even more risk and try to pick a winning stock.

That means your odds of picking a stock in 2011 that would have undone your bad luck in 2010 would be just one in a hundred.

What's all this mean? It means if you're a stock picker, you have to have discipline and never let losses get huge. Don't be the investor who rides shares of Eastman Kodak down to a penny stock.

Otherwise, stick with investing in diversified market indexes. Doing this greatly reduces your risk and takes away the danger your bad luck will put you in a bad spot.

Matt Krantz is a financial markets reporter at USA TODAY and author of Investing Online for Dummies and Fundamental Analysis for Dummies. He answers a different reader question every weekday in his Ask Matt column at money.usatoday.com. To submit a question, e-mail Matt at mkrantz@usatoday.com. Follow Matt on Twitter at: twitter.com/mattkrantz