It’s easy. The best investment is the one whose profits you keep. If your profits vanish because you –
Hold until your profit turns into a loss.
Hold until a small loss turns into a big loss, and then a huge loss.
Hold so long your annual return turns small even when you do profit.
Then you’re not making the best investment. So what can you do? You need to know about Exit Strategy and Position Sizing.
Never make an investment without knowing when and how you’ll get out. That’s called an Exit Strategy.
You should have an Exit Strategy before you invest in anything.
You should be able to write it down. Nothing fuzzy allowed.
Know what will trigger your sell order.
Good Exit Strategies let you keep your profits and cut your losses. That’s your best investment.
Wall Street Wisdom – “Cut your losses, but let your winners ride.”
A few big wins and many small losses can equal a win overall.
Never risk more than 3% of your portfolio in any one position. And that’s on the high side.
Why so small? Look at what it takes to recover from a loss:
Lose 50% of your portfolio, and you’ve got to make 100% on what’s left to recover your loss. Is 100% profit easy?
Lose 25% of your portfolio, and you’ve got to make 33.3% on what’s left to recover your loss. Is 33.3% profit easy?
Lose even 10% of your portfolio, and you’ve got to make 11.1% on what’s left to recover your loss.
Small losses leave you with enough capital to keep investing.
Control risk by controlling position size. The less you invest in any one thing, the less you risk. That’s your best investment.
Your Exit Strategy affects your Position Size.
If your Exit Strategy were to sell after a 25% loss, you could put up to $12,000 of a $100,000 portfolio into one investment, because –
$12,000 X 25% = $3,000 = 3% of $100,000
If your Exit Strategy were to sell after a 10% loss, you could put up to $30,000 of a $100,000 portfolio into one investment, because –
$30,000 X 10% = $3,000 = 3% of $100,000
You risk only what your Exit Strategy will let you lose, not your total investment.
Emotion is the investor’s enemy. People hold too long because of greed and fear.
Greed for even bigger gains. Fear of realizing a loss.
The best investment is mechanical.
Follow your Exit Strategy like a machine. Automatically. No matter what your feelings scream.
Place exit orders with your broker in advance.
Acting when the time is right makes your best investment.
Exit Strategies Explored
So what do Exit Strategies look like? Stop Orders are the best known.
Tell your broker to sell if the price falls to some specific point.
Some people use 8% below the purchase price. Others use 10%, 15%, or 25%.
Stop orders don’t always do their job.
The price can fall way below your stop point before your order gets filled.
Market makers sometimes sell to force a stock price down.
They want to trigger other people’s stop orders, so they can buy their stock cheap.
Stop Orders can also be used to sell when the price rises to some specific point.
Decide in advance on a good return –
Two or three times the amount you put at risk.
If you use technical analysis (if not, don’t worry about it),
sell near strong resistance, or
when the stock looks over-bought, or
when the trend changes, etc.
Stop – Limit Orders limit the price you’ll accept after a stop order is triggered.
You might not get out at all, if the price falls below your limit.
Trailing Stop Orders automatically raise the stop price if a stock price rises.
If you bought a stock for $50, and used a 10% trailing stop –
You’d sell if the price fell to $45.
But if the price rose to $60, your stop price would rise to $54. ($60 – 10%)
The stop price never falls after it rises.
Trailing Stop Orders are good ways to hold on to profits, but
Trailing Stop Orders may push you out of stocks sooner than you want.
Put Options work like insurance policies.
Buying a put lets you sell your stock for a safe price of your choice.
The cost of a put reduces your profit, but –
You’re safe, no matter what happens to the stock. That’s your best investment.