1) Averaging Down Often Dangerous

Everybody loves the story of the stock that plunges and then rebounds off its low to a big gain.

In mid-July, Bank of America (BAC) traded at 18.44 intraday, or 65% off its October high. Then, it roared to a 33.44 close, up 81% in six sessions.

Such cases can convince investors that averaging down — i.e., buying additional shares of a stock on the way down to lower the average cost per share — is smart portfolio management.

However, there are several problems with this method, which you may be hearing about recently.

First, averaging down exposes your portfolio to stocks that might go much lower, even bankrupt.

A stock en route to Chapter 11 can look like a turnaround candidate.

Even the pros can be fooled.

For example, Lehman Bros. received upgrades from analysts six months, 51/2 months, three weeks and one week before it filed for bankruptcy protection.

The analysts had their reasons. One said the risk of a liquidity crunch was fading. Another called the price "extremely attractive." A third said a takeover was likely.

The problem with averaging down is that it's often done in a situation that even pros have trouble gauging.

There's no way to know if "low" is truly low, if a stock will rebound, or how long a recovery will take.

Some losers never come back.

For those that do rebound, there's no easy way to identify the bottom. Many stocks will go into multiyear downtrends before rebounding.

Finally, a stock's decline is often partly driven by a weak market.

Telecom firm Lucent Technologies (LU) was one of the hot stocks in the late 1990s. When the tech bubble burst in 2000, Lucent fell sharply. An accounting scandal didn't help.

But here was your chance to pick up shares at 50 that had been, not far back, as high as 64. You could have bought more at 40. Soon after, 30. All you wanted at 20.

The stock eventually fell to below 3, and the company merged with French telecom Alcatel.

The truth is you never know how much a stock will fall. Even companies with good reputations can falter badly.

Cutting losses early will prevent you from getting stuck with an underperforming stock.

Instead, you can reinvest your money into a faster growing opportunity. That way, you minimize your losses and don't miss out on better opportunities.

There's no better evidence of that than last autumn's financial meltdown. Citigroup ©, Bank of America (BAC) and other major banking firms saw their share prices plummet. The venerable Bear Stearns and Lehman Bros. collapsed.

2) Keep Losses Manageable

Controlling losses keeps you in the game. You can wipe out a significant portion of your capital or blow out entirely if you don't learn to limit your losers.

If you bought shares at 100 and they're now at 93 or 92, close your position. Move on to another stock. If the stock that you just sold rebounds, you can always buy it back at a later time.

Yes, some stocks will snap back once you sell.

If you sell to cut your losses short and the stock does rebound, you can jump back into it when a new buying area forms. The important part is that your capital lives to fight another day.

Rather than wring your hands and hope for your stock to recover, raise cash and search for leading stocks as they break out of proper bases.

Investors might want to consider following a 3-1 ratio for taking profits vs. cutting losses.

That means if you're taking some 20% to 25% gains, then cut your losses at 7% or 8%. But if you're taking profits of just 10% to 15%, then get out at a 3% loss.

What about if you pyramided into a stock (which means buying some initial shares, then adding smaller amounts as the stock rises)? How does the 7%-8% sell rule apply in that case?

You have a choice if you bought shares in increments. You can scale out, selling at a 7% or 8% loss for each purchase, or just sell all of your shares at once.

3) Cut Your Losses, But Ride Out Your Gains

Nobody's right all the time. (Except, maybe, mothers. But that's a different story.)

With the right investment strategy, though, you can be right less than half the time when you pick stocks and still come out ahead.

Sounds too good to be true? It's no snake oil. Just simple math.

If you cut your losses at 7% or 8%, and let your winners run so you can take profits at 20% to 25%, you'll keep your portfolio ahead.

Cutting losses short is a rule often repeated. But that's because it's one of the most difficult to stick to. And because it works.

Why? Because investors tend to get all emotional about their stocks — they get attached and think, "It has to get better," and then they don't sell the laggards until they've already lost a load of cash.

Cutting your losses is the absolutely best defensive strategy when it comes to managing your stocks. When a stock starts losing money, it's usually just a bit here and there. That's exactly the best time to deal with it — before it can really do some damage to your portfolio.

When you see your stock fall 7% from your purchase price, the warning bells should be ringing. Dump that puppy now, and you only have to make 7.7% back to be even.

But guess what? Stick with that stock until it falls 25%, and it's going to mean that you have to see a 33% rebound before you get back to even. If you miss a sell signal, and you lose 50%, you have to notch a 100% rebound before you hit the break-even point.

So, if you buy a stock at 50 a share and it falls to 46, lose it like a bad prom date. Do not pass go, do not collect anything — just get rid of it. Employ your discipline.

If it turns out that the stock regains its previous glowing stature right after you divest, don't sweat it. Be glad you can be disciplined.

If the stock sets up in a proper buy point again, you can always buy it back. If not, you're safe and ready to invest again, with most of your capital intact.

But what if your stock isn't tanking, and instead is running up? You don't want to sell yourself short, literally.

If a stock shows no sell signals, you could try to hold it for a profit of 20% to 25%. Why this target?

Through research "successful stocks, after breaking out of a proper base, tend to move up 20% to 25%."

"Then they usually decline, build new bases, and in some cases resume their advances,"

If you're trying to decide whether to go for a huge gain on a current leader, look at its action. Did the stock gain 20% or more from a breakout within three weeks? If so, it might be a big winner. Try to hold such stocks for at least eight weeks.

Look at the firm's fundamentals. Leading stocks show outstanding quarterly growth because the firm has an innovative product or service. They also tend to be newer issues that went public within the past eight years.

Losses Compound

Keep in mind that the larger your loss, the more the stock has to work to erase its loss.

A drop of 25% requires a gain of 33% to break even. If you hang in for a 50% loss, your stock must turn and rise 100%. But if you pull the rip cord at 7%, you only need to make 7.5% on your next investment to rebuild your initial capital.

Moreover, as losses extend beyond 8%, the rebound needed to get back to break-even just keeps getting bigger and bigger.

An 8% loss requires a gain of just 8.7%. But a 20% loss needs a 25% gain to get even, and a 33% loss requires a 50% rise.

It gets even worse after that. A 50% loss needs a 100% gain to get back to break-even, and a 75% loss means that you need a 300% rise.

Another point to keep in mind is that you don't have to wait for a loss to hit 7% or 8% before you sell.