During my 16-year career as a Wall Street insider, I saw many fortunes made. Unfortunately, I also saw fortunes lost.
Among investors who lost money, the biggest reason was usually failure to protect profits and cut losses. Many investors are unaware that they can do just that by using a safe and effective strategy: the “trailing stop.”
A trailing stop is simply a stop-loss order set a certain percentage below the market – and then adjusted as the price rises.
So far this year, we’ve seen incredible volatility in the stock market.
Whenever a stock in our portfolio pulls back 25% from its closing high – or from our original entry point – we sell the stock at market.
Why do we depend on using trailing stops? Because they keep us from selling our stocks while they’re in a major uptrend – and prevent small losses from becoming unacceptable losses.
It’s true that many of these are great companies that will bounce back eventually. But “eventually” can be a long time. Our policy is not to argue with the market.
We buy based primarily on the near-term business prospects for our recommended companies. But we understand, too, that changes in fundamentals are immediately reflected in share prices. So that’s where we base our sell decisions.
Adhere To Your Trailing Stops, No Exceptions!
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If we don’t adhere to our trailing stops and start making exceptions, our system will break down. And then – like so many investors – we’ll simply be flying by the seat of our pants, hoping our stocks will continue to rise… or stop falling.
I know some investors object, especially if they have faith in a company…
- But you can’t bank on size and strength. Enron was the seventh-largest company in the United States.
- You can’t always depend on quality, either. At one time, WorldCom had the most impressive array of telecom assets on the planet.
- Nor will longevity protect you. Montgomery Ward was profitable for 100 years before declaring bankruptcy.
- And I’m sure you’re familiar with the long and storied saga of General Motors.
However, if time passes and we recognize that we stopped out of a company due primarily to market volatility and not business fundamentals, we will often recommend the stock again.
Know When To Sell
But it’s important to have a sell discipline and stick with it. Using trailing stops and knowing when to sell a stock is the true art of investing… Anyone can buy a stock.
In a study 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 differing approaches to selling stocks.
The result? Institutional managers who fared best were those with restrictive rules that did not allow leeway for hanging on to stocks for emotional reasons. The managers who relied on “flexible” sell strategies did far worse.
That’s unsurprising, really. When institutional investors see a stock moving against them, they are just as likely to rationalize as individual investors. And the culprit is always the same: pride, ego or emotion.
A Non-Emotional Sell Strategy
As Greg Forsythe, Director of the equity model development team at Charles Schwab, said, “Without any kind of sell strategy [e.g. trailing stops], emotions come into play. And emotions are almost always wrong.”
We recognize that our timing will never be perfect. (No investment system devised will ever beat the uncanny accuracy of hindsight.)
But, in our view, market prices generally reflect the prospects for a business better than “expert opinions.”
Using trailing stops protects both your profits and your principal. Not only by taking the emotion out of the investment process, but by basing your sell decisions on the realities of the market.
How A Trailing Stop Works
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 it’s just going through its normal fluctuations.
That can’t help but make you a more successful investor.
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.
