5-01 Ride Your Winners

Selling a stock is just as important of an investment decision as buying and you must have a strategy to maximize your profits and minimize your losses. Developing a trading strategy is important to your future investing activities. Even a flawed strategy is better than having no strategy. And trust me, your strategy will always be evolving as you learn from your past successes and mistakes, as the markets change, and even as technology and software change.

This lesson will teach you some generally accepted trading rules. But unfortunately, trading is an art — not a science — so don’t be shy. Create your own investing strategies as you grow and learn.

When you are learning a new skill, it always seems as though there are a few general rules of thumb that you must know in order to get started in the right direction. In golf you must “keep your left arm straight” (if you’re a righty) and in blackjack you must “assume the dealer has a 10.” In stock trading the first rule is:

Rule #1: Ride your Winners and Cut your Losers.

This rules looks simple and seems obvious, however, it is the opposite of what most people do when they start trading stocks.

There is a common affliction that hits most new investors that causes them to do the exact opposite—they can’t admit that they were wrong. This condition is best shown by example. Assume you invest $1,000 in two companies as your first two trades. After the first month, Stock A’s market value has increased to $1,200 while Stock B’s market value has decreased to $800. What is your first reaction? Is your first thought to sell your winner (Stock A) and take your profit, and wait until your loser (Stock B) regains its value? This is the LOSER’S mentality! Yet, this game plan is usually the first one followed by newer investors.

At first glance, it may appear to make sense. You sell your winner and take your profit and then you get emotional about Stock B and think “it will come back soon and I will sell it when I can get all of my money back.” Don’t do this! Many, many, many experienced investors would disagree with your plan – strongly disagree. See Rule #1—Ride your winners and cut your losers! This cuts your losses (and you WILL have some losses as everyone does). If your winner is “hot,” it’s likely that its market value will increase further. Similarly, if your “problem child’s” price is declining, the declines will probably continue, causing you to suffer further losses.

[mark] Gordon Gecko, the main character in the 1987 movie Wall Street, said it best when he said “don’t get emotional about stocks, it clouds your judgment.” You should only buy a stock after researching it and having a strong conviction as to why you want to own that stock—but if you are wrong, admit it and move on to your plan B.[endmark]

This concept can be understood better when looking at what it takes to re-coop your losses. This is NOT intuitive. You see, due to the way percentages work, it takes a much larger percentage gain to recover your losses. For example, for a stock that has lost 15% of its value will require a run-up of 18% just for you to break even.

These calculations get worse the more your stock goes down. Take a look:

My Stock LossGain Required to Break Even
20 percent25 percent
30 percent43 percent
50 percent100 percent

For example, if you buy Stock XYZ at $10 a share and it drops to $5 then you have lost 50% of your investment. Now for you to recoup your investment, the stock must now double just to get back to $10 a share. No one wants to be in the situation of having to pray for a stock to double, just so that they can break even. In fact, that’s a nightmare. It is much better for you to cut your losses early, at 8-12% rather than get into this predicament.

The law of percentages seen above also works in reverse (and in your favor) when you hold on to your winners. The longer you hold onto a winner, the less a stock needs to move in order for you to rack up really exciting gains. Let’s take a look at the table as stocks rise:

My Stock GainsGain Required to Double Original Investment
20 percent66 percent
30 percent54 percent
50 percent33 percent
75 percent14 percent

The gains get even better when your stock has doubled or tripled already. For example, let’s say you bought Google (GOOG) in 2004 at $100 per share. If the stock is trading now at $400/share, every 1 percent rise in the stock produces for you a 4 percent gain. Not bad, eh? That’s how you get rich: finding winners and sticking with them as long as they keep rising consistently.

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