The stock market is really no different from your own business. Investing is a business and should be operated just like a business.
Assume you own a small retail clothing store. You have bought and stocked shorts in three colors—yellow, green and red. The red shorts are quickly sold out, the green ones are half sold and the yellow ones have not sold at all. What do you do about it?
Do you go to your buyer and say, “The red shorts are all sold out. The yellow ones don’t seem to have any demand, but I still think they’re good and besides, yellow is my favorite color, so let’s buy some more of them anyway”?
The clever merchandiser who survives in the retail business eyes this predicament objectively and says, “We sure made a mistake. We’d better eliminate the yellow shorts. Mark them down 10 percent. Let’s have a sale. If they don’t sell at that price, market them down 20 percent. Get our money out of those ‘old dogs,’ and put it in more of the hot-moving red shorts that are in demand.” This is common sense in a retail business. Do you do this with your investments? And if not, why not?
Everyone will make buying errors. The buyers for department stores are professional buyers and even they make mistakes. When you do slip up and you recognize it, sell and move on. You do not have to be correct on all your investment decisions to make good profits.
Anytime a commitment in a security is made, you should define the potential profit and possible loss. This is only logical: you would not buy a stock if there were a potential profit of 20 percent and a potential loss of 80 percent, would you? But how do you know this is not the situation when you buy a stock if you do not attempt to define these factors and operate according to well-thought-out selling rules? Do you have any specific selling rules or are you flying blindly?
I suggest you consider writing down the price at which you expect to sell if you have a loss, as well as the expected profit potential of all the securities you purchase. By writing it down, you will focus your attention later on the fact that the stock has reached one of these levels.
Individual investors should consider adopting a firm plan to try to limit the loss on initial invested capital in each stock to an absolute maximum. Whatever decision you make in terms of the percentage loss you are willing to sustain is personal. What’s more important is that you have at least thought about the downside and you have some type of an action oriented plan.
Because of position size problems and broad diversification, most institutional investors do not usually follow tight loss-cutting plans. This is a major advantage you, the individual investor, have over institutions.
The late Gerald M. Loeb of E.F. Hutton wrote in his first book, “The Battle for Investment Survival,” that he cuts all losses at 10 percent (of the actual capital invested). In fact he once stated that he hoped “to be out long before they ever reach 10 percent.”
There is no rule that says you have to wait until every single loss reaches 10 percent or whatever you have determined as your stop loss, before you take it. On occasion, you can sense that the market or your stock isn’t acting right or that you are starting off amiss. Then you can cut the loss sooner, when a stock may be down only one or two points.
Whatever you set as your “stop loss,” is the absolute limit. Once you get to that point, you can no longer hesitate. You can’t think about it or waste a few more days to see what might happen. It now become automatic—no more vacillating—sell and sell immediately at the market. The fact that you are down by your limit below your cost is the reason you are selling. You don’t need any other reason. At this time nothing else should have a bearing on the situation. Good luck and remember, cut your losses and don’t look back.
Quote of the Week: “The manner in which one endures what must be endured is more important than the thing that must be endured.” – Dean Acheson
Bart Ward is the chief executive officer of Ward & Co. Ltd. an Anoka based registered investment advisor – specializing in the management of stock and bond portfolios in companies which are listed on the NYSE.