Most investors never fully think through the exit strategy for an investment. They get so carried away thinking about how well they will do with an investment that they don’t take the time to carefully think about how they will ensure the final profitable resolution of the deal. We’ll take a break from our discussion of bonds and look at why you must think through your final expectations so you know when to exit with a profit.
Think back to the late 1990’s… How many people saw a $100,000 investment grow into a Million Dollar war chest only to fall all the way back below the original $100,000? Many, many people fell into this trap. They had no exit strategy. The reason was that they had no idea what a reasonable expectation for return should be. They kept holding on thinking that internet stocks could just go up and up forever! Of course, this is not the case. If you’re riding a wave of unreasonable sentiment, you must get off while the wave is cresting. Understand this beforehand and have a plan to get off.
That’s an extreme example, but it holds true for any business or investment. What is your exit strategy to ensure a profit?
If we’re talking about your lifelong dream business, then the exit strategy may be to die and pass it on to your child who also loves the business dearly. If so, that plan should be well documented.
In most cases, this will not apply and so there is even more reason to have a plan to exit. Let’s look at two ways that you might plan to exit a security….
A value security becoming overvalued. Let’s say that you buy a stock (or perhaps an ETF representing an entire sector or region) because you notice that the market is undervaluing its earnings. If this is the case, you must have formed some opinion of what the true value of the company is. Let’s say that a company has a Price/Earnings Ratio of 6 and you feel that a valuation of 12 is more reasonable. If you buy the stock and then watch the price run up to a P/E ratio of 15, this might be your cue to exit. If you are a true value investor, you certainly would. You would see that the stock you own which was once a value oriented stock (because of its low price relative to earnings) is now an expensive stock.
On the other hand, you might be the type of investor to let a stock that is flying keep flying until it runs out of gas. If this is you (and again, you should decide all this beforehand!), how will you know when to sell?
The Stop Loss. The stop loss helps answer this question. If you’ve predetermined a percent loss that you’ll allow yourself to see before you cut ties with the investment, then that will be all that you can lose (unless the market is experiencing something extraordinary and you simply can’t get out until a much lower prices is established.)
An example would be to set a 25% Stop. If the price runs up from a P/E of 6 to 15, and then it falls back to a P/E of 11.25, then you would sell. (I’m using the P/E ratio for consistency here, but you would most probably use the share price to determine your stop.)
If you had determined this 25% as a stop loss from the beginning, then you would sell the stock when it hit a P/E of 4.5 (again you would be using share price). Thus you would know from the beginning that 25% is the most you are willing to lose on the stock and you would have to follow this rule without mercy to your pretty little stock. All too often investors get emotional about stocks and don’t want to let them go even when they are evaporating in value. The only way it is a “secure” investment strategy is if you use it.
A stop can be any percentage you choose. We’ve heard of investors having them as tight as 6% and as wide as 50%. You might always use the same stop, or you might use different stops depending on the particulars of a stock.
This is Part 19 in the series Investment Due Diligence. To use this as a growth tool to better understand your own calling, you might start by reading Part 1, Pt 2, Pt 3, Pt 4, Pt 5, Pt 6, Pt 7, Pt 8, Pt 9, Pt 10 , Pt 11, Pt 12, Pt 13, Pt 14, Pt 15, Pt 16, Pt 17, and Pt 18.