Market Direction is Crucial in Timing Trades: Beginning investors are often absorbed in finding the next miraculous upward moving stock, the lucky find that that will win them a fortune, overnight. They tell themselves that others have found fortune in the past, why can't it be done again? They study a few books and recognize that certain stocks at certain times do much better than the market average and with eager optimism they grow confident that they can spot the next big winner. They learn a few formulas notice a couple of visual patterns (some don't even bother learning the formulas) and with wonderful recklessness they invest their nest egg in a certain promising equity (often times a penny stock, which can turn out much worse). Within a short time the stock takes a dive and the investor loses his shirt. He wonders what went wrong?
Intermediate and even seasoned investors can also find themselves in the uncomfortable position of arguing against the market, going long when they should be short, or being bullish when they should be bearish, or vice versa. Jesse Livermore, a successful and seasoned trader of last century once commented "it takes a man a long time to learn all the lessons of all his mistakes. They say there are two sides to everything. But there is only one side to the stock market and it is not the bull side or the bear side, but the right side." 40
How Long to Hold a Stock: When asked the secret for getting rich Baron Rothschild was reported to have said; "buy cheap and sell dear." This is true, of course, but lets look closer at this statement and create a strategy to accomplish the aspiration by examining the question, how long should an investor maintain their position? Value investor Warren Buffett suggests that an informed investor should plan on holding a stock for a minimum of 5-10 years.41 Growth investor O'Neil has a plan of taking a 20% profit over the course of 3-6 months and sell at an 8% loss. And for stocks that are able to grow faster than 20% in less than eight weeks, hold them for a minimum of at least eight weeks42. Either system or a combination of both have proven successes records for the investors that employ them.
A good time to sell is when you look at a company's performance, pretend you don't own any shares, and ask yourself the question, would I buy it now with what I presently know? If the answer is no---then by all means sell. And for channel investors I would say forecast a target price and plan to sell at that point. Cut your losses quickly if the stock behaves way off the ordinary.
A Stop-Loss Plan: Investors often times find themselves in the position of owning stocks that go down instead of up. A situation that tends to happen in everyone's portfolio. Many value investors hold onto these lack luster equities because the finances are interpreted to be in decent shape and there is evidence of growth ahead. Peter Lynch said;
"My clunkers remind me of an important point: You don't need to make money on every stock you pick. In my experience six out of ten winners in a portfolio can produce a satisfying result... All you need is a lifetime of successful investing in a few big winners and the pluses from those will overwhelm the minuses from the stocks that don't work out."43Growth investors follow the same logic except that they perhaps tend to change positions more quickly. William O'neil (founder of Investor's Business Daily) suggests that beginning investors should take their profits at 20-25% and cut losses at 7-8%.
"By maintaining this 3-to-1 profit-vs-loss ratio you can be right on only 30 percent of your stock purchases and wrong on 70 percent and still not get into serious trouble...But whatever you do, the key is maintaining the 3-to-1 ratio...Be aware that when you sell at 7 or 8 percent below your cost, the stock may often turn around and rally to higher levels When this happens, you'll feel like a fool...But was it really a mistake?... Your preventing that 7 or 8 percent from slipping to 15 or 20 percent or much worse. Think of it as just another form of insurance..."44
One more thing traders should be aware of is that if you choose to invest in individual stocks realize that three out of four stocks, or roughly 75%, will go down when the market goes down.45 The Growth stocks that are typically chosen by short term traders usually have a greater volatility than the market itself. This is for a variety of reasons, they are young, often have less tangible value/assets to fall back on, less history. They tend to overcorrect. As a result the investor without a stop loss plan find that they have lost even more than the market itself. A big loss can turn the investor sour against stock trading and even the stock market as a whole.
Personal Example: Let me tell you about my first stock purchases so you can learn what not to do. Years ago I was a poor young college student and I decided to learn about internet trading. I had saved some money from working a retail job and wanted to invest and see what would happen. It was all new and exciting. High speed internet was new and information and technology had become reliable. I thought computer trading had the potential of bringing a great fortune and I heard about the wonderful profits people had made. I made a quick google search, spent a few hours learning chart analysis, and chose a discount online brokerage house. I waited a couple of weeks for my account to become activated and when it was, I was off and running.
I looked at the volume spike compared to the price movement and thought I found my golden star. I chose mglg an energy stock and purchased it at $32.00. The next day I checked it and wow! I was right on. It went up to $33.00 then $34.00 all the way to $37.00. But then a funny thing happened it started to go down and before I knew it, it was in the $20.00's. I remembered hearing my folks say "the stocks always goes back up. The only time you lose is when you sell." I followed that advice and stubbornly waited for the stock to go back up. I hid my head in the sand and waited weeks, even months. Did it go up? No, infact it continued to deflate and I finally sold when it was at about $6.00. Last check mglg is valued at exactly $0.00. I lost four months salary on that episode but learned a few valuable lessons. One being--don't argue against the market. You're either on the right side or the wrong side. If the wrong side, pull out quickly.
I also realized, as I contemplated my loss, that I had miscalculated the risk and not realized that individual stocks do indeed go belly up and fall into oblivion. If I was to trade individual stocks, then it was going to take much more research and understanding than just owning a 401(k) or mutual fund run by investment professionals. Also that if I was going to trade in stocks, themselves, I had to know everything I could about the stock, the sector, and even the market itself. I had to know the fundamentals backwards and forwards. I had to become suspicious of negative numbers, suspicious of high debt ratios, and most important of all I had to know the difference between the market pulling the stock down and bad fundamentals/management pulling a stock down.
Diversification: Diversification is an investment strategy that helps reduce the risk in owning stocks. The thought is that if an investor owns one or two equities and there is trouble it could forever shake him out of the market for good. But if there are more positions the chance of them all going down is far reduced and there is greater chance of at least one or two great performers.
Jim Cramer author of Mad Money suggests one hour of study per week per stock invested in, with a minimum of 5-6 stocks for diversification46. Peter Lynch suggests between three and ten47. It takes a great deal of study and thought to invest in stocks. And then the investor has got to be ready and quick to pull the plug when they aren't going right. Is it worth it? Can the investor win at this game? Yes, of course, but just beware that it takes dedication and study to succeed.
In diversified portfolio when a trader is following a system of sell when the benchmark is reached sometimes the investor is left with the underperformers, having cashed in on the fast growers previously. Peter Lynch calls this "pulling out the flowers and watering the weeds." He suggests that better strategy would be to exit from a stock, "if a stalwart has gone up 40%--which is all I expected to get out of it--and nothing wonderful has happened with the company to make me think there are pleasant surprises ahead, I sell the stock and replace it with another stalwart I find attractive that hasn't gone up."48
________________________________________________________________________ 40. Reminiscences of a Stock Operator, Edwin Lefevre, p. 50, 2005 edition 41. The Warren Buffett Way, Robert Hagstrom, p. 160, 2005 edition 42. How to Make Money In Stocks William O'Neil, p. 103, 2002 edition 43. One up on Wall Street, Peter Lynch, p. 18, 2000 edition 44. The Successful Investor, William O'neil, p. 28, 2004 edition 45. The Successful Investor, William O'neil, p.1,22, 2004 edition 46. Real Money, Jim Cramer, p. 71-75, 2005 edition 47. One Up on Wall Street, Peter Lynch, p. 240, 2000 edition; 48. One Up On Wall Street, Peter Lynch, p. 243, 2000 edition