The Most Important Thing That You Need To Know About Investing
That is a very grand title for a newsletter. But, I kid you not, what I am going to discuss this month is a rather overlooked but massively important factor in the success or failure of an investment strategy.
Every serious investor has thought through this element of 'the game'. Quite simply, if they have not, they are not.
So what can be this important?
SELLING.
Simple, huh?
Of course it is. When it comes down to it, most things in life are really quite simple. So is this. But, oh-so overlooked.
If you begin to study investment as either a hobby, an intellectual pursuit or a profession, you will find massive quantities of books that can guide you. I know, I have quite a few of them. However, the majority will help you to choose an investment. Stock or fund picking is a vital element in the investment process.
But, selling is where the profits are. After all, if you never sell, you never really make a 'real' profit, it is just a theoretical one. And theoretical profits do not pay the bills.
Years ago, I used to know a semi-retired farmer in the UK. He was a nice guy who had sold a pig farm whilst it was profitable and was living on his large 'capital'. He found investing to be more regular as an income source! (At least that is what he said.) Without trying to be mean, he wasn't the sharpest knife in the drawer and his investments backed my theory up.
The first time I was invited to his house he delighted in firing up his pc to show off his investment software and display to me his 'portfolio'. At the time he had holdings in about 100 different UK listed companies. But, about 70% of these holdings were losing money! I was amazed. He had boasted to me that he had 'never made a loss on a share'. Being unable to resist, I quizzed him relentlessly that evening until I found an answer I believed.
The truth was that he had bought all these shares but had NEVER actually sold one. He had not made 'a loss' because he didn't turn the shares back into cash. It also meant that he had never actually made a profit either but he neglected to mention that...
As you might be realising, this did not make him a good investor. He had not figured out how to either buy or sell shares. It was all pure dumb luck either way! When you also consider that I am talking about perhaps 1996 or 1997, towards the end of the greatest share bull market of all time, he was doing worse than pure dumb luck!! During the world's most profitable period for investment EVER, he had found a way to lose money consistently. That takes real skill.
Most people that invest money will never make the kind of errors of judgement that this man made. Most people will never have the money available to lose and it not alter their lifestyle. That may be a blessing in disguise!
With hindsight, as I got to know him better, I began to realise that he was actually a gambler at heart ... horses, cards, shares, spoof (though I never figured out the rules to that) and I'm sure more that I wasn't aware of.
However, most of us are not gamblers. We have some spare money and we want to invest it for the future. Hopefully, it will grow into something more substantial for when we need it. Perhaps it will pay for a child's education or our retirement. Whatever.
The issue that you need to think about when making an investment is when to sell up. The reason is quite simple, it is all about discipline. Even the best companies go through bad times. The course of a business cycle virtually guarantees this. We however, want to be selling during the good times for a profit, not holding on until it is too late for a loss.
Some investors have a preset figure in their mind - when the price is xx I'll sell. Others use a stop-loss system, or better yet, a trailing stop-loss. Each has a place in the investment world.
Alas, we can't all behave like Warren Buffett and buy with the intention of holding 'forever'. Firstly, he is better at this than us. Secondly, he tries to buy a business whole, which is probably out of your reach (I know it is out of mine!). And lastly, though I know he will hate to make a loss more than most other people, if it all goes wrong, he can afford it. His life will not be ruined by losing money (and he has been so successful that even his reputation is unlikely to be ruined).
Just remember that the simplest formula for making money in an investment is to 'Buy low and sell high'. Easy stuff. But when things are high, you need to remember to sell. Don't let greed get the better of you.
It has happened to me and probably every investor who ever lived. He or she held on too long and turned a decent profit into a sickening loss.
Last time, I wrote about the importance of selling when it comes to making money in the investment markets.
Simply put, even the best investment in the world will lose it's appeal sooner or later. When that happens, or when another investment looks even more inviting and potentially profitable, a reallocation of capital involves selling up and moving on.
Of course, there is another side to this: capital protection. Either your investment has increased substantially and you do not want to lose the gains you have made, or, the price is falling and you want to protect the capital initially invested. Either scenario involves monitoring of your investment and making a sale when you start to become nervous.
The easiest way to protect your capital when making an investment in shares or funds of some sort is by using a 'stop-loss'.
Quite simply, a stop-loss is a mechanical way of triggering a sale. For example, if you buy shares at 100p and don't want to lose too much if they fall and you are / were wrong, setting a limit at which you sell is a useful solution. You might set that limit at 10% or 15%. That would mean should the shares fall to 90p or 85p, you automatically sell.
This has some good and bad features as a system. Firstly, it is difficult to apply to shares that are highly volatile. If the shares often move by 5% or more in a week and a stop-loss set too closely to the current price, it might force you to sell when you would rather not. In those circumstances, a limit of 20% or more may be more appropriate.
On the plus side, if you really do need to protect your capital at all costs, selling should the price move against you is a vital way of protecting yourself. Sure, you may guarantee to lose 10%, but if the price keeps on falling, you may have saved a lot of money indeed. Shares often rise or fall in a rather predictable way - when things are good and a company is growing and generating good profits, prices rise and rise. If however, things are bleak and losses are being made, the fall can last for months or years and massive amounts can be wiped from a company's value.
It therefore makes sense to try and benefit from this trend, this is why many people use a 'trailing stop-loss'. This is a more active track of share prices and performance and is designed to let you (and I'm quoting a very famous investment saying) 'run your profits and cut your losses'.
To use a trailing stop-loss, set a number of points or percentage below your current share price. This will be your minimum - the automatic trigger to sell if the price is breached. However, should the share price rise, your stop-loss is moved upwards in the same ratio as the share price. Thus, your trigger will still be (for example) 15% below the current price, but that will be higher than it once was.
The further up a price goes, the farther the trigger is reset. This has the effect of locking in a majority of your profits. Should the price go into reverse, you sell at your new higher level, but if the price keeps rising and rising, you get to profit from those gains.
Now obviously, if I have just explained the above in a few paragraphs, it is far to simple for fund managers and investment bankers to be following. They have complex computer programmes that calculate how a price has moved in relation to an index, a sector and the rest of a portfolio. Decisions are far more complex. This of course is for pro's that manage dozens of shares and not the likes of us that manage a few at a time. But for managing a few at a time, the above is a simple and effective method to lose much less and profit more in the market.
If you want to really see it in action, the best thing I can suggest is to find a few sheets of graph paper, draw a graph and start following a share price each day. Add the stop-loss at, say, 10% below the current price and keep plotting the graph over a few weeks. Every time the shares hit a new high, increase that stop-loss. If the share price stays the same or falls just plot an extra day without altering the stop-loss. Pretty soon, it will all become very clear and remarkably simple to operate.
The Most Important Thing...
Hybrid Mode
