It’s not much different than what regularly happens in the produce department at the grocery store. Places like Safeway (NYSE:SWY) always replenish the tomatoes and the like to keep them fresh.
You should do the same with the “inventory” in your portfolio because if you let your stocks sit on the shelf too long, they’ll eventually go bad - just like fruit that’s past its expiration date.
Here are some of my favorite tactics to help you lock in profits instead of letting irrational behavior and emotion take over when the markets suddenly have a mind of their own.
1) Recognize every day is a new day
This one is very simple. If the original reasons why you bought something are no longer true, ditch it – win, lose or draw.
You can’t risk falling in love with your assets any more than you can let them rust – yet that’s exactly what most investors do. They buy something then assume that it will somehow plod along on autopilot.
This is a variation of what I call the “greater fool theory” as in some greater fool is going to come along at a yet-to-be-determined point in the future and pay you more for a given investment than you paid to buy it.
I can’t imagine what these folks are thinking.
Today, more than ever, you’ve got to continually re-evaluate your investments to ensure that they stand on their own merits and are worth the risk of continued ownership.
2) Sell into Strength
Most investors have been taught to let their winners run. I’m all for that – don’t get me wrong – but ask yourself why the professionals take money off the table whenever they’ve got winners on their hands.
Answer – they know that the longer a bull runs, the higher the odds of a reversal.
That’s why they begin “lightening up” or systematically selling positions or even portions of positions when prices are rising. We use the same philosophy at Money Map Press.
Investors who have grown used to the “set it and forget it” approach typically don’t like this method. They argue that they will leave money on the table if something keeps going up.
Of course, they’re absolutely correct. Selling prematurely can lead to reduced profits.
But what I am talking about has nothing to do with selling early. In today’s markets, I think it’s far more important to recognize that systematic selling when the markets are rising and liquidity is high helps you a) lock in profits before a reversal arrives and b) reduces the potential for future losses.
And if the markets continue to rally?
That’s a logical question I get all the time. My response is always the same…so what?
If a rally has legs, there’s nothing stopping you from redeploying your gains into new opportunities. Hopefully, you’ll be smart enough to manage those, too.
3) Use trailing stops
This sounds pretty self-explanatory but you’d be amazed at how many people I talk with every year that don’t use them, despite the fact that most brokerages and online trading platforms have these features built in and available for free.
Trailing stops, in case you are not familiar with them, are essentially price targets that work in reverse.
They are typically calculated as a percentage of purchase price. For instance, a 25% trailing stop on Apple (NASDAQ:AAPL) at $657.41 is $493.06. If the stock dropped to $493.06, the order would execute and carry you out of the trade.
Variations include specific dollar-based stop losses, calendar stops and contingency orders – all of which typically rise in lock step as the price of your investment rises.
What I like about trailing stops is that they offer an unemotional, unbiased exit path when any investment begins to move against you. But that’s the catch. You have to give up some ground before you’re carried out of the trade.
As is the case with any investment strategy, there are people who don’t like trailing stops because they get bounced out of trades that seem to immediately turn around and head higher without them.
I can’t say I blame them. Floor traders, hyperactive day traders and quants with computers that would make NASA envious love to “shake the monkeys” from the trees and “run the stops.” Both are euphemisms for deliberate actions intended to exploit the protective actions of others for gain.
It doesn’t bother me most of the time because I have an investor’s mentality. Therefore the daily volatility associated with this kind of gamesmanship is just noise and hitting the occasional stop is just part of the game.
If I am day trading, that’s another matter entirely – and a subject for another time because setting trailing stops in a day-trading environment is a discipline all its own.
4) Buy put options
Buying put options is a more sophisticated variation of a trailing stop that gives those who use it more control over the sales process. The drawback is that the cost of your investment goes up because you’re effectively buying “insurance” against a loss.
For instance, if you bought 100 shares of Facebook (NASDAQ:FB) today at $20 and wanted to limit your losses to 25% of your purchase price, you could place a trailing stop at $15 a share. Your initial investment would be $2,000 (ignoring commissions and fees for the sake of simplicity) and you’d be selling your shares automatically if the stock dropped to that point.
Or, you could buy 100 shares of Facebook today at $20 and simultaneously purchase a November $15 put for $0.70. Your initial investment would then be $2,000 plus the cost of the option or $2,070 (again ignoring fees and commissions).
As the price of Facebook shares drop, the price of the put option you’ve purchased goes up, helping offset the loss you would otherwise be incurring. If shares of Facebook rise, the value of the put option generally drops.
If Facebook is trading above $15 on November 16, 2012 when the put option in this example expires, you lose the $70 and you’ll have to buy another put option to “protect” your investment further, which means your cost basis goes up again.
If Facebook is trading below $15 on November 16, 2012, the option goes “in the money” and helps limit your loss to the difference between your purchase price of $20 and the strike price of the put option which, in this case, is $15 (excluding fees and commissions for simplicity’s sake).
On a related note, some people like to sell call options against their stock as a means of offsetting losses incurred as a stock drops.
While I can understand the merits of doing so, I’m not a big fan of this strategy because it’s very hard to sell enough options over time to pay for the loss associated with a given investment particularly if there’s a catastrophic move to the downside, especially under current market conditions.
5) Set profit targets
I’ve saved the best for last. It’s setting simple profit targets.
Like trailing stops, profit targets are usually set in percentage or dollar terms.
I’m a big fan of profit targets because they offer an unemotional path out of the market and ensure discipline no matter how emotionally attached I become to a particular investment.
Unlike many investors who constantly shoot for the moon, I don’t see the need to be greedy. Depending on my expectations and market outlook, I’ll set realistic profit targets that can vary widely.
For conservative choices, 10% over a few months might be good. For more aggressive recommendations, banking more than 100% in only a few weeks or even days may be appropriate.
Either way, if and when an investment hits my price target, I’ll sell with no questions asked and bank the gains. I almost never look back.
Many investors like to think they’ll do this but, in reality, find that they get sucked into the moment because they confuse the potential of additional upside with very real need to manage the risks associated with staying in the game longer than they have to.
You might think this is not a big deal. I beg to differ – any time you attempt to second guess the markets you are, in effect, introducing a timing element into your decision making process. That’s one of the most costly errors you can make.
As I noted earlier this summer, trying to time the markets is an exceptionally bad idea – 85% of all buy/sell decisions are incorrect, according to Barron’s.
Further, the latest Dalbar data shows that the return of an average investor trying to time the market is a pathetic 1.9% per year versus the S&P 500 return of 8.4% over the same time period. Over 20 years, that’s the financial equivalent of taking a 342% hit in lost performance.