Common Investing Mistakes: Selling with Your Emotions
by Steven Samblis
Each month in this column we talk about the most common mistakes that investors make (hence the title). My endeavor is to offer you real world techniques and solutions that will help protect your portfolio and make you a better investor.
This month I would like to focus on conquering an area that is a major problem with experienced and novice investors alike. I am referring to the emotions of fear and hope. You must learn to take these emotions out of the equation. When allowed to run their course, these nasty little emotions offer nothing short of doom to an investment portfolio.
It is natural for fear and hope to creep in while you are making decisions about your portfolio. However, when applied to investing, these emotions will cause you to work backwards. Most people will watch a stock fall in price and wait to sell until it is too late. This is a natural reaction. They wait, hoping that the stock will bounce back, looking for a reprieve from their loss. The same investor sells his stock when it moves up 10%, resulting in the loss of all the potential upside as the stock continues to rise. The investor is afraid that he will lose the profit already gained if he does not sell right now. This emotion is natural as well.
To succeed, however, an investor should be afraid he will lose all his money if he does not get out of a falling stock. He should also leave a rising stock alone. As a rule the investor should be afraid of selling rising stocks too soon, thus missing out on upside potential.
The emotions of fear and hope are hard to change. Instead of trying to conquer them in one fell swoop, we will try using automatic techniques to guide our investing activities. So instead of conquering the emotions, we will remove them from the equation.
This month we focus on the use of automatic orders that limit your losses within a preplanned limit. This technique is referred to as a stop-loss.
In simple terms, a stop-loss is an order that you place with your stockbroker. With a stop- loss you give your broker a dollar price that will trigger the sale of your stock when it drops below that value. This method will take the emotion out of the equation. Your own emotions can crush you (I have seen the enemy and he is I) . Most people sell when they are scared, or worse yet, do not sell because hope takes over. They hope that the stock will come back, but it falls to nothing while they sit back and just watch in horror. With a stop-loss the sale automatically happens at the current market price once your stop-price is triggered, meaning no more watching and hoping. If a stock is not acting as planned, get out before it is too late! Heed the words of Jesse Livermore, said to be the greatest trader in the history of the market. Livermore said... "The market will tell the speculator when he is wrong, because he is losing money. When he first realizes he is wrong is the time to clear out, take his losses, try to determine the cause of his error, and await the next big opportunity."
How do you use a stop-loss? Let us look at an example:
Lets say that you wish to own 1000 shares of XYZ stock. You purchase XYZ at a price of $20.00 a share.
1) Your next step is to determine your down side risk tolerance. Just how much price fluctuations to the downside are you willing to stomach as you hold your stock for the value you believe is possible? Remember, all stocks move up and down. Even though a stock may have momentum for a period of time to the upside, they all show corrections on the way up. A stock going the right direction will move up, pause, move down a small amount, then begin its upward trend again. Traders call this action "creating a base". (Example: The price of XYZ stock moves from $20 to $25. It then moves down to $23. As time goes on it moves up to $30, down to $27, creates a new base and moves on up to $35 a share. ) As long as the upside movement continues to be greater than the down side corrections, your stock will increase in value.
So, how much down side should you be willing to take? There are dangers here. If you say, "I'll accept a fluctuation of 10%" (which in this case would be $2.00), that may not be enough. You might have your stop triggered during what is normal price fluctuation for the stock. You would end up selling to soon. If you place your stop loss at 50% ($10.00) you will have lost half your money before you sell.
A good rule of thumb is setting your limit at a 20% stock loss. This is enough to allow for normal price swings and at the same time curb your losses to acceptable levels. So lets say you go with the 20% stop-loss. You tell your broker to place a stop loss at $16.00 a share (Purchase price of $20.00 -20% = $16.00) .
2) The next step is to go fishing. No really, I don't mean this metaphorically. Go fishing, hiking, or do whatever else you enjoy doing. Step away from the computer and have a little fun! With your stop-loss at $16.00 a share, if -XYZ begins to fall and trades at a price of $16.00 a share, your stop becomes market order and the stock is automatically sold at the market price. Will you get $16.00 a share? Maybe not, but you will get out at the current market price. It may be higher or lower then $16.00, but at least you are out and not risking any more of a decline.
3) Next step - Revisit your stop-losses weekly. When you return from your fishing trip on Friday, check you stocks. If you have not been stopped out of XYZ, and the price is now $35.00 a share, call your broker and raise your stop loss to $28.00 (The new price of $35.00 - 20% = $28.00)
4) Rinse thoroughly and repeat. You get the idea?
By setting a stop loss of around 20% you are much better off than someone that watches the market all day just to lose half their investment during a bathroom break. With the stop loss technique you don't have to watch the market. Your broker will initiate the trades for you based on preplanned limits.
Remember, market prices will swing up and down. It is important to have a plan to protect yourself when the swing becomes a free fall. The stop loss is a good start in that direction. It also is just another way to remove some of the emotion and stress out of investing in the markets.
Next time we will talk about the other side of stops. I'll teach you a way to automatically sell when it is time to take a profit. Till then, get the uses of stop losses down and you will find the world of investing becomes a lot less stressful and much more profitable place. |
