One of the key criteria to astute investing is to consider when and how you will take your profits – in other words, you need to consider your exit strategy before you invest. Most investors never give this any consideration because when they invest they expect the asset to rise. And while the asset may rise, the value of the asset is not realised until you sell. Consequently, this is considered unrealised profits as the asset could fall in value. Therefore, you need to consider how and when you will exit if your investment turns sour or does not perform as expected.
Unfortunately, many investors mistakenly believe that if they have not sold a share that is falling in value then they are not losing. But let me demonstrate why the opposite is true.
If I buy a blue chip share that is rising in an uptrend, I know with high probability that the stock will rise a minimum of 20% in price over the next 12 months. Let’s assume I invest in five stocks throughout the year. Four of the stocks rise in value (all by 20%) and only one makes a loss (also by 20%). Now let’s convert this into dollar terms. If I invested $1,000 in every stock then I would have made $200 on each winning trade and lost $200 on the losing trade; therefore I would make $800 and lose $200, which would give me a net profit of $600 or a 12% return on my capital of $5,000.
Now let’s assume I decide to hold onto the stock that was falling in value, because I believe there is a chance it will turn around and start to rise. However, by the time it has decreased by 50% in value I realise that this is not going to happen. So what is the effect of this on my portfolio? On the losing trade, I lost 50% or $500, meaning the unrealised net profit changes to only $300 ($800- $500 =$300) or 6% profit on my $5000 capital. By allowing the losing trade to fall below 20% halved the return on my portfolio from 12% to 6%.
The longer a stock continues to fall the greater the effect on your overall profitability, which is why it is so important to ‘cut your losses short and let your profits run’. In essence, allowing your losses to run into bigger losses turns a good investment strategy into an average one.Dale Gillham is the director and founder of Wealth Within, an Australian-based company specialising in share market education and independent investment advice. Dale is the author of the book ‘How to Beat the Managed Funds by 20% and Australia’s first and only accredited Diploma of Share Trading and Investment. For information visit www.wealthwithin.com.au