Risk Management Strategies
These are some of the strategies that are mentioned in William J. O'Neil's book, How to Make Money in Stocks. It makes sense to have a DEFENSIVE plan to go along with your purchasing strategy. Always try to learn from your past mistakes, and use these suggestions as a guideline.
The Red Dress Story!
This is a favorite of O'Neil's examples on how to invest in the stock market just like you would run a business. For a minute, let's suppose you own a small retail women's clothing store. You have bought and stocked women's dresses in three colors- yellow, green and red. The red dresses are quickly sold out, the green ones are half sold, and none of the yellow dresses have sold. What are you going to do?
Do you go to your buyer and say, "The red dresses have sold out. The yellow ones don't seem to have any demand, but I still think they're good and besides, yellow is my favorite color, so let's buy some more of them anyway"?
No! The clever merchandiser who survives in the retail business eyes his predicament objectively and says, "We sure made a mistake. We'd better eliminate the yellow dresses. Mark them down 10%. Let's have a sale. If they don't sell at that price, mark them down 20%. Get our money out of those "old dogs" and put in more of the hot-moving red dresses that are in demand." This is common sense in a retail business. Do you do this with your investments? Why not? Do you have any specific selling rules, or are you just flying blindly?
The 7% - 8% Rule!
Seriously consider adopting a firm plan to limit the loss on each stock you buy to a maximum of 7% - 8%. Once you are down to that point you should no longer hesitate. You don't need any other reasons, because the simple fact that you are down 7% - 8% is all the reason you need.
This is kind of like insurance. You sell to make sure you don't suffer a catastrophic loss. Granted, there will be times when the stock you sell will turn around and immediately go up. You will probably get very perturbed and think you made the wrong decision if the stock rebounds.
Suppose you bought fire insurance on your house last year. Just because it didn't burn down, are you upset because you made a bad financial decision? Fact is, you don't buy fire insurance because you know your house is going to burn down. You buy insurance just in case, to protect you from the remote possibility of a very serious loss.
Some people have even damaged their health agonizing over declining stocks they were holding. It is best to sell and stop the worrying. You have to accomplish a very critical objective of keeping your losses small, even if a number of the stocks move up after you sell them. Letting your losses run is the most serious mistake made by almost all investors! If you aren't willing to cut short and take your losses, you probably should not buy stocks. Would you drive a car down the street without brakes? Probably not!
Investors are always hoping rather than being realistic. Everyone loves to buy stocks; no one loves to sell stocks. As long as you hold a stock you have hope that it might go up enough for you to get back even. Once you sell, you abandon all hope and accept the cold reality of defeat. You can't afford to have a love affair with any stock.
A great trader once said, "There are only two emotions in the market - hope and fear. The problem is we hope when we should fear and we fear when we should hope."
Averaging down is usually not an effective strategy for making money in the stock market. The fact is, in most cases, you should already be out of the stock before you ever even reach the point where you're considering averaging down your cost. Wouldn't it make more sense to buy a stock that is strongly performing in the market, rather than more of one that has broken down? Usually when a stock has dropped in price there is what is referred to as "overhead supply" or, in other words, there are a group of people who bought it higher and many of them are now looking to get out of it. These people view the stock as a "dog" and are anxious to sell each time it gets back up to around the price they got into it. It is only after the stock breaks through the overhead supply (resistance) that it is likely to have a dramatic rise in price.
Plenty of people still will insist that averaging down is a smart thing to do. You might want to be prepared for a long wait, especially if the company has had a disappointing earnings report, which is often the case when stocks have fallen off sharply.