One of the biggest challenges many investors face is selling out of a winner.
Selling out of a loser is easy — and in fact, many traders dump stocks too soon because of the bad feelings they get from watching the tape. But selling a big winner is like parting with an old friend that has been good to you, and much harder to do.
You can take the guesswork out of selling, though. Protect your gains by using two simple methods for all your big winners: Either take partial profits or set a trailing stop loss.
Taking “partial profits” is what it sounds like. If you have 100 shares, sell 50 or 60 and let the rest of your shares ride things out. By doing this you take some money off the table and protect it from evaporating should things sour. And by leaving a smaller position in your favorite winner, you remain tapped in for future gains. It’s a win-win.
Let’s say you bought 1,000 shares of XYZ Corp. at $5 and it has doubled to $10. Your $5,000 investment is now $10,000. So if you sell 500 shares, you have cashed out your $5,000 … which you can either spend on a nice vacation or reinvest in other stocks. The remaining 500 shares will continue to move up and down based on how XYZ performs in the future.
If you’re very bullish on a stock, maybe you only want to sell 20% or 30% of your stake. Or if you made a huge gain, maybe you can sell 50% or 60% and still have a substantial amount of skin left in the game.
Taking partial profits is also important because it allows you to rebalance your holdings and prevents you from being “overweight” in a single position. Let’s again look at the example of XYZ Corp. If it’s one of 10 stocks in $50,000 invested, it represents 10% of your total to start (remember, a $5,000 initial investment). But after it runs up it now represents over 18% of your portfolio ($10,000 in a now $55,000 portfolio, if all other investments are flat).
It is never a good idea to allow a single stock to represent such a huge portion of your total holdings. Taking partial profits allows you to “rebalance” and move your money around to diversify and limit your risk.
But what if you believe in your high-flier so much that you can’t bear to part with it? Well, in this case, I strongly recommend using trailing stop losses.
Stop losses are downside targets that trigger an immediate sale. Using the example of XYZ Corp., if you place a stop loss of $8, you will be fully invested and enjoy any future gains but liquidate your position as soon as the shares drop to $8 or lower.
Consider it a safety net of sorts that prevents you from crashing all the way down to your original buy price — or lower — if things change in a hurry.
Of course, there are risks to both methods.
With partial profits, obviously you are taking money out of a stock and could miss out on future gains. Sure, you’ll still make some money — but you’ll also miss out on some.
And stop losses can sometimes be triggered by a brief dip in shares. Let’s say XYZ dips to $8 and triggers a sale, then rebounds to $12 a day later. Well, you got “stopped out” so you missed that rally.
However, in my experience it is crucial to limit your risk and protect your profits, and investors who put the prospect of big gains ahead of limiting their losses often wind up doing as much harm as good.
So next time you have a big winner, consider taking partial profits or setting a trailing stop loss.
After all, the only thing worse than selling out of a stock too early is watching a big winner give up everything and eventually move back into the red.
Jeff Reeves is the editor of InvestorPlace.com and the author of “The Frugal Investor’s Guide to Finding Great Stocks.” Write him at firstname.lastname@example.org or follow him on Twitter via @JeffReevesIP.