Money

The Importance of Exits

One of the things that separates successful traders from the rest of the market is that they have a plan for getting out of a company, whether it be at a loss or a profit. The planning and execution of exits is far more important than the planning and execution of entries.

Whilst trading routinely involves decision making, there are no more important decisions you have to make than when to sell shares. Many traders often overlook this part of investing or underestimate how important that it is. It is selling that impacts directly on whether or not you make any money trading in the sharemarket. Buying shares is simply a means of putting yourself in a position to make money trading.

Hopefully, one of the things that will separate you from the majority of market participants, is that you are going to have a detailed plan that will guide you when to sell shares. This is essential. It is fair to say that when most investors buy shares they have little idea of under what conditions they would consider selling. Most of these people adopt a ‘buy and hold’ approach.

There are a number of effective ways of selling both for a profit and a loss, and they all basically follow two time tested trading rules. They are:

* Cut your losses, and
* Let your profits run

To cut your losses is to sell shares after making a small loss to ensure that further losses are not sustained. To let your profits run is to allow solid performing shares to continue without selling them too early, with the aim of determining how high they will go before you consider selling them.

It is not the manner in which you decide to sell that is important, but the fact that you have a plan in place to advise you when to sell. What is also important is that you remain consistent in whatever approach to selling you adopt.

As a trader, selling shares is probably the most difficult decision you will face but it is the most important. The decision is especially difficult when you are faced with a loss and all you want to do is wait for the shares to return to your buying price. The situation is made worse when the shares continue to move away from you, making your loss even greater than you would have ever imagined.

There are a number of reasons why people will not sell shares when they are faced with a loss. It is prudent that I detail these at this point before we even consider tackling the issue of when to sell. If you do not understand some of the psychological biases that we have and how they directly impact on our behaviour, then moving on to the rest of this chapter would be futile.

Consider the emotions in a person who is contemplating cutting a loss. Cutting a loss means that you purchased some shares and they went down. Your initial decision to buy was wrong and selling the shares at a loss validates your mistake. Cutting your loss means accepting that you were wrong and unfortunately there are many people who cannot bring themselves to do this. Yet, it is essential.

Some of the best traders in the world are very humble people because they have to be. They realise that they can’t be right all the time.

When you think about it, it is really no big deal. Of the more than six billion people on earth, not one of them knows what is going to happen in the sharemarket tomorrow or the next day or the day after that. No one else knows so how can you expect yourself to know for sure? Obviously, you can’t.

There is a typical experiment which is conducted in Economics and similar classes, which relates well to selling shares. It involves dividing a room of people into two groups. Everybody in the first group is handed an imaginary coffee mug. The second group receive nothing.

Everybody in the first group is asked to write down on a piece of paper how much they would be prepared to sell their coffee mug for. Everybody in the second group is asked to write down on a piece of paper how much they would be prepared to buy the coffee mug for.

The amounts from all people within each group are compiled and an average calculated for each group. Generally speaking the average amount from the owners of the imaginary coffee mugs is double that of the average amount from the potential buyers of the coffee mugs. This observation supports the Endowment Theory.

The Endowment Theory suggests that people who own something place a greater value on it than those who do not have it. This is applicable trading, and can affect your decision making when deciding to sell shares that you should be selling. Often you will find yourself owning shares and believing that they are worth more than what the present share price is.

The only unfortunate thing about that is the real price is what it is presently trading for on the market and not what you think it should be worth. Unfortunately, your opinion matters none.

This can affect us by convincing us not to sell shares when we may be best advised to sell them to stop any further potential loss. You may have bought shares for $4.00 and set an initial stop loss at $3.50 for example. A week later the shares are trading at $3.50 and you have received your cue to sell them.

Thoughts enter your mind about how it was only a week ago that you paid $4.00 for them and how you think they are still worth that especially when you consider the report they released last week concerning future growth.

These thoughts can paralyse you to take no action and not cut your losses and consequently have you breaking one of the most important time tested rules you can follow.

Several years ago, I conducted a seminar in Melbourne and in preparation for one of the sessions, I asked all the attendees to write down on a piece of paper the worst investment they had ever made in the sharemarket. All responses were anonymous so people were quite honest.

I asked them what the company was, how much they bought the shares for and when, and if they have sold them, for what price and when. I also asked them to note what percentage of their investment capital that individual investment represented.

The responses were overwhelming.

They included people who had invested their entire investment capital into one company and still own the shares with the share price well below their purchase price. It also included examples where companies were delisted and the shares worth nothing. Unfortunately the above situations were the rule rather than the exception.

I then took the three worst investments from the group and broke the group into three smaller groups of about 15 people each. Each group was handed a summary of one of the worst investments that I had selected including a price chart to show them what the share price had done over time up to the present day.

I gave each group 15 minutes to study the chart and the information concerning the investment, to establish feasible reasons why the person did not sell the shares at a more appropriate time.

To say the groups experienced difficulty in developing some possible scenarios is an understatement. With the benefits of hindsight and 15 people to discuss the situation, they struggled to develop suitable reasoning for why the investor did not sell a lot earlier and have saved a great deal of money. Yet, when that trader was faced with that situation, they thought of every excuse they could to justify not taking action and holding on and hoping for a better outcome.

15 people with hindsight could not come up with any reasonable excuse for the inaction yet the person involved at the time came up with ample excuses. I think this example speaks very loudly for how important it is for you to recognise how critical your selling is, but also how we can easily be influenced to do the wrong things by our emotions.

There is a small exercise that I often conduct in seminars which helps further demonstrate the difficult issue that we face when confronted with both profits and losses – it is shown below.

Consider this situation: there are two boxes as shown below and each have some marbles in them. The first box has 4 marbles – 3 blue and 1 red and the second box has only 1 green marble.

In the first instance, you have the possibility of making money. You are able to take only 1 marble from one of the boxes, therefore you have a choice of which box you take a marble from, although you can’t see inside the boxes.

If you place your hand in the first box and pull out a blue marble, you receive $1000. If however, you pull out the red marble, you gain nothing. Your other choice is to place your hand in the second box and pull out the green marble knowing that it is the only marble in there – in this case, you receive $700.

My experience has been that the vast majority of people I have shown this to in seminars will elect to take the green marble and the $700. You may think the same way as you read this.

In the second instance, the situation has been changed slightly although the original boxes and marbles are left in place. The only difference this time is that you face losing money. Instead of making $1000 or $700, you now face the possibility of losing those amounts.

If you place your hand in the first box and pull out a blue marble, you have to pay $1000. If however, you pull out the red marble, you have to pay nothing. Your other choice is to place your hand in the second box and pull out the green marble knowing that it is the only marble in there – in this case, you pay $700.

My experience has been that the vast majority of people I have shown this to in seminars will elect to take their chance and place their hand in the first box in the hope they pull out the red marble and therefore won’t have to pay anything.

This simple exercise demonstrates how we react when faced with winning money and losing money and therefore is very applicable to trading.

In the first situation, you faced the possibility of winning, and you had two choices. The two choices involved a risk and a certainty. The risk was that you would pull out a red marble from the first box and miss the blue ones, and therefore make nothing. The certainty was the second box where you could easily pull out the green marble and make $750.

The second most important trading rule is ‘let your profits run’ and to do this requires you to be risk seeking. Most people when faced with the first situation adopt a risk averse behaviour by selecting the certainty – the green marble. People are quick to take a profit because they fear losing it. In other words, when faced with a profit, people will generally have a tendency to steer away from the appropriate trading behaviour.

In the second situation, you faced the possibility of losing money and again the two choices were available. Most people select the risk seeking behaviour by hoping they pull out the red marble and don’t have to pay anything – the last thing people generally want to do is just give up money without exploiting a chance where they don’t have to pay anything.

The most important trading rule is to cut your losses and this requires a risk averse behaviour. Most people when faced with a loss don’t cut it and therefore adopt a risk seeking behaviour by opening themselves to further loss.

Successful traders when faced with a loss have no hesitation in cutting that loss and moving on with the next trade. By cutting their loss they are completely eliminating the chance of any further loss. Successful traders when faced with a profit are prepared to let that open position continue and possibly develop into a more profitable position. This simple exercise confirms how most people’s natural thoughts and tendencies are to do the opposite of what the time tested trading rules would have them do.

A character trait that I observed amongst many of the successful traders I have known is decisiveness. This was especially the case when one of their positions moved in the wrong direction and needed to be sold to cut the loss. Their actions involved not a hint of emotion or hesitancy. Don’t be influenced by some of the factors that have been mentioned briefly here; factors that can easily affect your decision making if you are not aware of them.

There are a number of ways of selecting exits, whether they are for profit or for taking a loss. However, what is important is that you are consistent in your approach to setting exits and you stick with your trading plan.