This guest post is by Troy from MarketHistory.org I enjoy nerding out on his site where he discusses historical and current events, news, themes, and fundamentals that impact the U.S. stock market. I asked Troy to write this piece about when to sell your stocks because it was probably this biggest lesson I learned when I started investing. I learned to mitigate my risk early on, but once an investment started going in my favor I didn’t know when to get out and would end up losing all of my profits. It took me time to realize I needed a solid exit strategy and a backup plan set aside before entering an investment otherwise you end up flying blindly. The lessons below apply to all types of investing from Day Trading, Swing Trading, Real Estate, Venture Capital, entrepreneurship, a path to early retirement, etc. Whatever you do always keep your end goals in mind. Here’s Troy.
There are 2 parts to every successful investment: buying at a good price and selling at a good price. Oddly enough, many people have strategies regarding “when to buy” but don’t create strategies for “when to sell”. Buying at a good price ensures that your investment’s risk is reduced, while selling at a good price allows your profits to run. The real money is made by cutting your losses and letting your profits run.
Before you make an investment
There is risk involved in every investment or trade. There is no such thing as a “risk free” asset. Even U.S. Treasury bonds have risks associated with them. Perhaps one day the U.S. government will default on its mountain of debt!
That is why before you buy any stock, you must consider the 2 sides to every investment. Risk and reward.
Risk is the MAXIMUM potential downside on your investment.
Reward is the MINIMUM potential upside that this investment might yield.
What you deem an investment’s risk and reward to be completely depends on your own analysis of the stock.
Why do we compare maximum potential downside with minimum potential upside? Why not maximum downside vs maximum upside? It’s simple. We want to be conservative with all of our estimates. We want to have a margin of error in our calculations. Like Warren Buffett said, “the first rule of investing is to not lose money, and the second rule is to follow the first one”. If you lose 50%, you’ll need to make 200% just to get back to breakeven.
When you invest, you should stick to the 2:1 rule. This means that a good investment has a minimum risk:reward ratio of 2:1. So for every $2 of minimum potential upside, there should only be $1 of maximum potential downside.
This skewed ratio ensures that over the long run, your profits will more than exceed your losses.
Once you’ve found an investment that has a risk:reward ratio which exceeds 2:1, you need to think about protecting your portfolio from a large drawdown.
When will you take a loss?
Ask yourself this question. If your investment is losing money, when will you sell and get rid of it? When will you throw in the towel and admit defeat?
Sticking to your investment “forever” is not a good idea, because some stocks just keep falling and falling (like RIM, which used to be a huge phone maker). Sticking to your investment is basically saying a Hail Mary and praying that the market will turn around in your favor. As investors, we should not bet on blind luck.
By deciding at what price you will take the loss BEFORE you make the investment, you will avoid the emotional mistake of sticking with a bad investment “just because I don’t want to lose money”. No one wants to admit that they’re wrong.
There are many different ways to decide when to take a loss.
- Some investors set a simple % target. For example, they say that “if my stock falls 20%, I’ll sell the stock and take the loss. Such a big decline in the market probably means that my market outlook was wrong”.
- Other investors set a time-related target. They say that “if my investment isn’t profitable after 6 months, I’ll sell the stock and take the loss. A real winning stock should have been profitable by the 6 month mark”.
- We choose a different approach. We only trade the S&P 500 via a quantitative model. Our model has a backup indicator that tells us when our market outlook is wrong. For example, our model will normally say “buy stocks”. But if the stock falls far enough and our model says “sell”, then we’ll gladly take the loss.
How you decide to take a loss is completely up to you.
When will you take a profit?
Before you make an investment, you need to have a VAGUE idea about when you will take a profit. This idea should not be set in stone because your market outlook must adapt as time goes on, new events emerge, and the fundamentals change. The vague guideline is simply there to give you a frame of reference.
How you decide to take a profit ultimately depends on your strategy and what stock you’re investing in.
- Fundamental investors in growth stocks typically stay in their investment until either the fundamentals deteriorate (i.e. the growth story changes) or until the stock is very overvalued. When a company’s fundamentals start to deteriorate, the stock price can AT MOST rally a few quarters on the sheer momentum of the price run up. But after that, the price is bound to move in the same direction as its fundamentals. Insanely overvalued stocks can indeed become more overvalued, but holding onto these stocks is very dangerous. It doesn’t matter if the stock can rally 2x, 3x in the next year because “momentum is on its side”. If the stock is overvalued, it might fall 90% within 2 years. That is not a good risk:reward ratio.
- Some technical investors wait until the stock is very overbought (e.g. a very high daily RSI) and the chart patterns hint that the market is about to turn down. We do not use this method because charts don’t have a very high hit-miss ratio. Even the best chartists only get the market’s direction right about 60% of the time, which is why they use sound risk management strategies to minimize their losses.
- Alternatively, we stay with our investment until our model says that the trend is about to reverse. Our model does not give a static price target for when to sell. Instead, the model’s price target changes as it’s fed updated fundamental and price data.
*Having a hard-line sell target is not a good idea. If you stick with an idea like “I will stick to the investment until it gains 40%”, you might be missing out on a real winner that yields 300% over the next few years!
Note from EQ: Here’s an example of what was discussed in this post. The below chart represents the visual game plan and execution of a day trade I made on the morning of Wednesday, May 3rd over the course of 2 hours.
In this trade I risked $0.26 cents per share for a minimum potential profit of $0.45 cents per share a risk reward ratio of 1.7 to 1. My ultimate target to make $1.27 profit per share had a risk reward of 4.9 to 1. I eventually sold my shares off for a $0.55 per share profit which resulted in a 2.1 to 1 ratio.