Monday, February 3, 2014
"What do you think about this company?" Adam asks me.
Uh oh. I know what's coming. He's about to show me a stock that has fallen a whole lot...
My friend seems to have the worst luck in the market. He buys at the top and sells at the bottom. It's so bad, it has gotten to be a joke around the office.
But the worst part is that he never knows what to do when a trade turns against him...
"I know it's down a lot," he says. "But I don't want to sell."
"Alright," I say. "When will you want to sell?"
That's always a stumper for him. He's got no plan. So he's going to worry all the way down... Eventually, he'll give up and sell at the bottom. Again.
If that sounds like you or someone you know, I'm going to tell you what I told Adam...
"The solution is easy. It'll take you about three minutes, a scrap of paper, and a pen. And you'll never have this problem again."
All you need to do, I told Adam, is write down three things BEFORE you make a trade.
That's the hardest part. I know you're enthusiastic about getting into the market. I know you're thinking about all the money you're going to make. But you just need to take a few minutes first.
Start with why you're making the trade. You don't have to get too detailed. Just write down what you hope to happen and when you hope it'll happen.
Something like, Acme Corp is cheap and it's trending higher. Its new product is catching on. I expect it to go up 20%-30% this year.
Or maybe, Acme is a dominant company in its sector. It pays a generous and growing dividend. It's buying back lots of shares. I expect to compound my money at 10% a year with this for at least a decade.
If you're prone to making trades after getting a "hot tip" from a buddy, this step will really help you. Make sure you've got a good reason before you put your money to work.
Next, write down how much risk you're willing to take on the trade. This can be just a plain dollar figure that you're willing to lose. Think about flushing that money down the toilet. Think about lighting it on fire. If that's extremely painful, lower the amount.
I suggest keeping this number under 1% of your total portfolio. So if you have a $50,000 portfolio, you shouldn't risk more than $500.
If you find yourself avoiding your brokerage statement because the losses have become too large, this is an extremely useful idea. It's like if you go to Vegas and you only take $500 cash. Once you burn through that, you're done.
Keep in mind: That doesn't mean you can only put $500 into the trade. It just means that once the trade is down by $500, you'll walk away.
And that brings me to the final step... This is absolutely the most important step. This step will save you from yourself.
You need to write down what conditions will cause you to sell the stock. If you know why you bought the stock and how much you're willing to lose, this part should be easy.
If you buy Acme for a large capital gain in a short time... and the stock is slowly grinding sideways... you'll get out. If you buy because you expect a new product to be a hit... and it's a flop... you'll get out. If you buy to compound your cash with growing dividends... and the company cuts its payout... you'll get out.
In short, if your reasons for making the trade are no longer in place, you'll get out of the trade. Resist the urge to find a new reason to keep holding. There are better opportunities out there.
And even if all your reasons for making the trade are still in place... but you're losing more money than you agreed to put at risk... get out.
Finally, you can add a "trailing stop." That way, if the trade goes in your direction, you can make sure to lock in profits.
That's it. It should take about three minutes to write this stuff down. You can fit all this information on a 3x5 card.
One last thing: Make sure to WRITE THESE THREE THINGS DOWN.
You might think it is good enough just to think these three things through before you make a trade. But when it moves against you, you'll find yourself making all kinds of excuses for not selling. You'll find yourself in the same old situation – worrying and losing money.
But if you've written these three things down – if you've made a "contract" with yourself – you're much more likely to stick with it.
You won't ever need to wonder if you should exit a trade. You'll know. And you'll have this list to remind you.
Amber Lee Mason
DailyWealth classic: "Buying stocks is easy... But buying is only the first half of the equation when it comes to making money," Steve Sjuggerud writes. "Nobody ever talks about the hard part – knowing when to sell." To be a successful investor, you need to have an exit strategy for every position. Learn more here.
Coffee prices are quietly surging... coffee fund JO hits its highest level since September.
Retail downtrend continues as sector fund XRT breaks down to a four-month low.
Tech giant Google soars to a new all-time high after latest earnings announcement... shares are up 56% over the past year.
Casino boom continues as Wynn Resorts breaks out to a new all-time high... up 73% in the past 12 months.