Why we don’t sell bad investments (and how to change)

A few years ago, speaking at a seminar for CPA Australia, I discussed the need for an exit strategy for our investments, just like we have our exit strategy in business.

When I asked the CPAs attending if they would advise a business owner to sell if they were running an unprofitable business, the resounding answer I got was ‘Yes’. I then asked if their advice would be the same for any unprofitable investment. The room went silent.

Interesting, isn’t it? In general, we can be objective with business decisions, yet with investments the decisions are often emotionally-based.

In my recent post, Selling for profit or just selling out, I discussed how it is more important to know when to sell an investment than when to buy one.

I’ll give you some strategies to achieve this, but before I do, we need to discuss why people don’t sell.   

In short, it is because people are afraid of losing. If the stock is in profit, they fear losing potential profit; if the stock is in loss, they fear realising that loss. But here are the facts: no one person can have a 100% success rate in picking winning stocks. Given this, and as the decision to continue to hold losing shares in a portfolio (as I discussed) is detrimental to returns, then it stands to reason that everyone needs to have a strategy for selling their investments.    

One of the most important rules is to trade on confirmation rather than speculation. As such, you will never buy a share at its lowest price, nor sell it at its highest price. The reason is that you must see a move occur in a particular direction before you react. This is called “momentum trading”: you enter a share when momentum is moving the share price higher and exit when momentum is moving it lower. The best investors and traders all have rules around identifying when this is occurring.

So, let me give you some insight into exit strategies.   

Exit Strategy 1: Set a “stop-loss” ratio

Stop-loss means what it says: stopping losses. The ratio is the percentage below the price you paid for the stock.

So, if your intention is to hold blue-chip stocks for the medium- to-long-term, my suggestion is that you use a “stop-loss set” at 15% below your purchase price. 

Remember, you need to let a stock settle into a trend after entering and if you set a stop loss too tight (say 5% of your buy price) there’s very little room for the stock to move, and you will decrease your probability of success.

In fact, setting tight stop-losses on shares is in my opinion the most common reason traders and investors fail. As I mentioned above, that strategy comes from the fear of loss, but the end result is actually getting more of what they don’t want: losing.   

Exit strategy 2: Set a sell ratio on profitable stocks

If a share you own is in profit, a simple exit strategy is to sell when the price falls 15% from any high price. This allows the price of the share to unfold fully, and gives you the opportunity to capture a large part of the upward movement. It is a much better exit strategy than selling when you reach a price target. Who knows how much higher the price might go? But I have lost count of the times I have heard investors or traders tell me that they will sell a share when it hits X dollars. That strategy is more aligned with gambling than wise investing.  

Exit strategy 3: Use a trend line

Another very successful exit strategy or tool I use is called a trend line. Space does not permit me to explain it fully here, which is unfortunate because I reckon more than 90% of people who tell me they use this tool don’t know how to use it. In short, a trend line is a trailing stop-loss tool that allows you to enter and exit a share while capturing a good proportion of the available profit of a trend. Here’s a brief explanation. 

Whether you are a trader or an investor, your job is to always take the lowest possible risk for the return you want each and every time you enter into a trade. In my book How To Beat The Managed Funds By 20%, I discuss stop-losses, trend lines and a variety of portfolio management techniques in much more detail.

Let me say: if you decide to heed my advice on exiting investments, you will become more profitable. On the other hand, enter an investment without a good exit strategy and you are gambling with your money. Unfortunately, gamblers lose more often than they win.