I don’t know how you’re fairing in all this market turmoil. If you’re anything like me, these nasty selloffs produce a whole gamut of emotions.
There’s the self-directed disappointment — the thought, ‘Why didn’t I see this coming?’ Perhaps you did see it coming but didn’t act on it. It might be just pure frustration at the mess the world economy seems to be in. Or anger at the short sellers that continue to push share prices lower.
A big part of how you react to this kind of market depends on what your investment goals are. If you really are a genuine long term investor — someone who might hold shares for decades — then you might see the current market as another opportunity to add to your existing shareholdings. It might even be a chance to add shares in a company that has up until now traded out of your reach.
And if you’ve been around the market a while, it might all seem a bit familiar. Just another painful part of the cycle before the market changes direction again.
For many, though, a lot of the frustration comes from confusion over what their true goals really are. We’ve all done it. You do your analysis and buy into a company for the ‘long term’, only to dump the stock when it takes its first hit.
Logic dictates that if your analysis determines a company to be great ‘value’ at $5, then surely it has to be even better value at $4. But logic can quickly go out the door, especially when emotions take over.
Quite often when we buy into a stock, we have some vague notion about where we might exit it. A price level yet to be determined, but somehow we’ll know when we get there. We get too consumed with the anticipation of the purchase rather than the mechanics of the exit.
But a near 600 point sell off, as we’ve seen in the first six weeks of this year, can very quickly put such vague notions to the test. All of a sudden, the stock that you were planning to keep forever gets thrown overboard in a moment of panic.
And you might be right — the stock could easily fall much lower. But it’s not really a methodical way to run an investment strategy. And you know that you’re only going to kick yourself if you see it trading back at a higher level sometime in the future.
While we might have very clear reasons for buying a stock (good fundamentals, growing return on equity, cash flow positive, sustainable yield), working out when to exit is much more difficult.
When I started out as a trader on the floor of the Sydney Futures Exchange, an old hand gave me three very clear rules:
- Always make a profit (a profit being a 1 point move). If you can’t do that, then
- Never lose any money (exit your position at your entry price). And failing that,
- Always lose as little money as possible (take your loss straight away and get on to the next trade).
Sounds ridiculously simple, but what made it work was that we were operating in such an extremely finite time frame. A short term trade might only be a few seconds as the price traded at both the bid and offer in different parts of the pit.
A long term trade might be one that went for an hour or so. Our definition of a long term trade? A short term trade gone wrong. In a nutshell, you were hoping for the price to come back for you. I had a very simple stop loss — the moment I knew that all I was doing was ‘hoping’, then I took my loss and exited the trade straight away.
But what makes share trading or investing much more difficult is the time frame. If you bought shares in the IPO of Commonwealth Bank [ASX:CBA] back in 1991 for $5.40, then you would be sitting on some very handsome gains — that’s including the huge selloff in banks that got under way in April last year.
However, over this time frame, you would have seen many huge fluctuations. Many forget that CBA traded as low as $24 in January 2009. Someone who ran a tight stop loss strategy since the IPO would have been stopped out countless times — an argument they might use to justify not using a stop loss at all.
However, share traders working on shorter time frames need to use stop losses for two reasons. First, to give their trade enough room to make a profit. That means, not taking a profit early or exiting just because they want to. And second, to protect their capital.
Whatever the time frame, though, the underlying reason for exiting a stock needs to be based on something very clear. That is, what price does the share need to hit to prove that the trade is no longer valid?
Some may use a technical point, something on a chart. For others, it might just be a fixed dollar amount or percentage of a portfolio.
The difference between the pros and many private investors is that the pros have rules. Rules that dictate that they must exit a trade if it falls by a certain amount. Rules they can’t bluff their way around or ignore if suits them.
Quite often a private investor’s stop loss amounts to no more than their pain threshold. How long they can hold on; not at the point that proves their trade is wrong.
If you keep hold of your capital, you can always re-enter the stock at a later date (if it once again meets your investment criteria). Or you might decide to allocate your capital to a better investment. If instead you ride a stock to the floor, then you’ll only be watching that one thing.
Nobody enjoys these kinds of markets. But if you take your head out of watching each move down and take the time to assess your strategy, you’ll be in a much better position to capitalise when the market changes direction again.
Editor, Total Income
Ed Note: The above article was originally published in Markets and Money.
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