Don’t Lose Money: The Most Important Law of Lasting Wealth

[MadMarketScientist 11]

Let’s face it – most people don’t know when to sell a falling stock. So they’re frozen into inactivity, saying, “Should I just keep holding and hoping, or should I cut my losses now?”

 

This state of indecision is usually permanent, and often continues until you hear the all too familiar phrase, “well, it’s too late to sell now.”

 

One of my good friends lost it all following the “it’s too late to sell now” principle. He bought a ton of shares in a cable company based on his friend’s recommendation that it was supposed to take over the world. The shares soon tumbled in half, and his friend, who knows about the cable business, told him to buy more, so he did. The shares tumbled in half again, and he bought even more. He finally stopped buying when the shares hit a dollar a share. The shares eventually traded for pennies.

 

After you’ve read today’s essay, if you follow the advice in here, your constant state of indecision will be gone. You’ll never lose another night’s sleep worrying about which way your investments will go tomorrow. Because, unlike most investors, you’ll have a plan – knowing when to get out, and when to stay in for the biggest possible profits.

 

Buying stocks is easy. There are thousands of theories out there for why and when to buy. But buying is only the first half of the equation when it comes to making money.

 

Nobody ever talks about the hard part – knowing when to sell.

 

In order to invest successfully, you need to put as much thought into planning your exit strategy as you put into the research that motivates you to buy the investment in the first place. So please read closely here, and think about each point...

 

How Do You Evaluate Businesses?

 

In business and in stocks, you’ve got to have a plan and an exit strategy. When you have one, you know in advance exactly when you’re going to buy and sell. The strategy I’m going to show you will allow you to ride your winners all the way up, while minimizing the damage your losers can do. But before I get into the specific strategy, consider this business example...

 

Let’s say you’re in the tee-shirt business. You’ve made a ton of money on a tee-shirt business in the States, and you’re now in the Bahamas looking for new opportunities. You size up the market, and you figure you can make money in two markets: in golf shirts, geared at the businessman, and in muscle-tees, geared toward the vacationing beach-goers. These are two products clearly aimed at two different markets.

 

You invest $100,000 in each of these businesses. At the end of the first year, your golf shirts are already showing a profit of $20,000. But the muscle-tees haven’t caught on yet, and you’ve got a loss of $20,000. There are numerous reasons why this is possible, so you make some changes in your designs and marketing and continue for another year.

 

In the second year the same thing happens – you make another $20,000 on your golf shirts, and you lose another $20,000 on your muscle-tees. After two years, the golf shirt business is clearly succeeding, and the muscle shirt business is clearly failing.

 

Now let’s say you’re ready to invest another $100,000 in one of these businesses. Which one business do you put your money into? The answer should be obvious. You, as a business owner, put more money toward your successful businesses. But as you’ll see, this is the opposite of what 99% of individual investors in America do...

 

How Do You Evaluate Stocks?

 

Let me start by asking you a question – what does “owning shares of stock” actually mean? This isn’t a trick question – as you know, it means you’re a partial owner of the company, just like you’re the owner of the tee-shirt company in this example.

 

Owning your own business isn’t fundamentally any different than owning a share of a business through stock. However, most people treat them exactly the opposite...

 

Let’s say the shares of your two tee-shirt companies trade on the stock exchange.

 

They both start trading at $10 a share. At the end of the first year, the profitable golf-shirt company is trading for $12 a share, and the unprofitable muscle-shirt company is trading for $8 a share. At the end of the second year, the golf shirt company is trading at $14, while the muscle shirt company is trading at $6 a share.

 

Which shares would you rather own?

 

Even though you know you should buy the winning concept based on the business example, most investors don’t do so in their stock investments. They keep throwing good money after bad hoping for a turnaround. They buy the loser.

 

The Trailing Stop Strategy

 

In stocks (and in business, I believe), you must have and use an exit strategy – one that makes you methodically cut your losses and let your winners ride. If you follow this rule, you have the best chance of outperforming the markets. If you don’t, your retirement is in trouble.

 

The exit strategy I advocate is simple. I ride my stocks as high as I can, but if they head for a crash, I have my exit strategy in place to protect me from damage. Though I have many reasons I could sell a stock, if my reasons don’t appear before the crash, the Trailing Stop Strategy is my last ditch measure to save my hard-earned dollars. And it works.

 

The main element to the Trailing Stop Strategy is the 25% rule. This is where I will sell any and all positions at 25% off their highs. For example, if I buy a stock at $50, and it rises to $100, when do I sell it? If it closes below $75 – no matter what.

 

Don’t Let Your Losers Become Big Losers

 

So with my Trailing Stop Strategy, when would I have gotten out of the failing muscle-shirt business? You already know the answer.

 

Remember, the shares started at $10 and fell immediately. Instead of waiting around until they fell to $6 as the business faltered, using my 25% Trailing Stop, I would have sold out at $7.50. And think of it this way – if the shares fall to $8, you’re only asking for a 25% gain to get back to where they started. But if the shares fell to $5, you’re asking for a dog of a stock to rise 100%. This only happens once in a blue moon – not good odds!

 

Take a look at how hard it is to get back to break even after a big loss...

 

You’ll Never Recover

 

Percent fall in share price            Percent gain required to get you back to even
10%                                                11%
20%                                                25%
25%                                                33%
50%                                                100%
75%                                                300%
90%                                                900%

 

So what’s so magical about the 25% number? Nothing in particular – it’s the discipline that matters. Many professional traders actually use much tighter stops.

 

Ultimately, the point is that you never want to be in the position where a stock has fallen by 50% or more. This means that stock has to rise by 100% or more just to get you back to where it was when you bought it. By using this Trailing Stop Strategy, chances are you’ll never be in this position again.

 

This article syndicated from Steve Sjuggerud's Daily Wealth