Investment U

There are a number of theories about when to cash in your chips. But most of them are misguided. And some are completely wrongheaded.

For example, any analyst who urges you to sell a stock because the market is about to tank is immediately discredited, in my view. While there are certainly many bear markets and bull markets ahead of us, no one – and I mean that literally – has ever demonstrated any proficiency at warning investors in advance.

The #1 Way to Know When To Sell Stock and Protect Your Principal

If there is truth to any of the great maxims of Wall Street it’s this one: cut your losses and let your profits run. Selling a rising stock, by definition, is not letting your profits run.

There is, however, one sell discipline that forces you to do just that. It’s called a trailing stop. And if you’re not using one to protect your stock positions, you should be.

A trailing stop is simply a stop-loss order set a certain percentage below the market – and then adjusted as the price rises. Let’s use a 25% trailing stop as an example.

After buying a stock at $20, you would immediately place a sell stop at $15, 25% below your purchase price. Under no circumstances should you lower your stop. It’s there to protect your principal.

However, you should adjust it upward as the stock begins to rise. When the stock hits $30, for instance, your 25% sell stop would be at $22.50, guaranteeing you a double-digit gain. When the stock hits $40, your sell stop would be at $30. And so on. This maximizes your gains – and ensures that your profits never slip through your fingers.

Traders, who are short-term oriented, will always want to run their sell stops closer than long-term investors. But even a short-term trader shouldn’t run his stops too close to the market. Why? Because no stock moves up in a straight line. And you don’t want to get knocked out of a winning stock while its just going through its normal fluctuations.

There is plenty of research to back up the idea of running trailing stops, incidentally.

The Best Money Managers Are Strict

In a study recently published in The Journal of Portfolio Management, Christophe Faugere, Hany A. Shawky and David M. Smith – finance professors at the State University of New York at Albany – researched the performance of money managers who oversee pension funds, endowments and high-net-worth accounts.

Because most institutions work under strict investment guidelines, these academics were able to analyze performance based on different approaches to selling stocks.

The result? Institutional managers who fared best were those with restrictive rules that did not allow much leeway for hanging onto stocks for emotional reasons. The managers who relied on “flexible” sell strategies did far worse.

Count me unsurprised. Institutional money managers are just as prone to rationalizing as individual investors.

The culprit is almost always pride, ego or emotion. As Greg Forsythe, director of the equity model development team at Charles Schwab, recently said, “Without any kind of sell strategy, emotions come into play. And emotions are almost always wrong.”

By adhering to a disciplined trailing stop strategy, you can mow down emotion-driven trading errors like a field full of dandelions. It cures greed. Eliminates fear. And does away with wishful thinking as in “I hope this stock turns around and starts going the right way.”

Trailing stops are a very effective way of managing risk. If you don’t have a sell discipline, you’re probably flying by the seat of your pants.

And in the world of investing, that’s the number one cause of pilot error.

Good Investing,

Alex

Today’s Investment U Crib Sheet

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