Most investors have experienced failure in their investments. While some managed to learn from their mistakes, others may continue to get burnt in the volatile market. However, we do see a number of highly successful cases in stock market investment. We may think that the success rate during good times is higher than bad times, but, by having a game plan, we may actually be able to increase our chances of success, especially during bad times. At the end of this article, you will be able to identify the strategy to tilt your chances of success and how it will affect your investment decisions.
Logically, in order for us to make money, we must be able to hold on to the right stocks. There is a famous saying in the investment world: ‘cut your losers early and let your winners run’. The question is, how do we do that? One way is to set a target price, which is usually a certain percentage above our purchase price. Upon reaching it, we sell the stocks and lock in our profit. However, in a down trending market, when the price is going down, our target price will never be achieved, and we will most likely end up holding the stocks longer than we expect as the market goes down. If the stocks are of good fundamental, then, this should not become a worry as we can always wait for it to appreciate in price at a later date. However, if during that period, the company’s fundamental has gone wrong, we will end up making losses by keeping a stock that that values lower than our purchase price.
Stop-loss strategy – managing down side risk
In investment, managing downside risk is equally as important as making profit. Therefore, we should also have a strategy to stop investment loss in down trending market. A stop-loss strategy is basically setting a target price, below which, we should sell off the stock holdings. Depending on individual tolerance limit, we can set the target at a 10 or 20% below the purchase price. Usually a higher percentage is allowed for a stock that is more volatile in nature while a narrower tolerance limit is applied when the market is full of uncertainty. For instance, if we purchased a stock at RM10 and the stock price is fluctuating in both directions, we may apply a 20% downside limit to set the selling price. If the price falls to RM8 or below, we should sell off the stock. In the event that the price appreciates to RM11, then the limit price should be readjusted to RM8.80.
On the surface, this strategy seems to be logical and easy to be implemented. However, when it comes to actual execution, many are unable to sell even when the price breached their tolerance limit. This is mainly due to the fact that to sell a stock at a loss is always much more difficult than selling at a profit. Psychologically, when we sell our stock holding at a loss, it means that we have to overcome our pride as we have to admit that we have made a mistake in purchasing it. In addition, many will also fear that after the stock being sold off, the price may appreciate again. Therefore, because of pride and fear of regret, a lot of investors will end up holding their stocks when the price goes down as they are still hoping for the price to go up again in the future.
Some may question the need of a stop-loss strategy as we can always treat our stock holding as a long-term investment. However, if we are having only limited capital, by selling the stock off when the price is going down, it actually helps to free up some of our capital which we can use it to purchase other stocks with better potential. For example, if we sell off Stock A at RM9 that we purchased at RM10, and use RM8 to purchase Stock B (with Stock B being of equal or better fundamental that started with RM10 and now has dropped to RM8), when the price appreciates back to RM10, we would have made RM1 profit versus if we do nothing and continue to hold on to Stock A. Alternatively, we can also choose to sell off the stock and hold the cash to wait for the stock price to go down further before buying it back at a lower price.
This is a strategy that helps investors to manage their downside risk, especially during bad times to ensure investors will not get caught in situation that tie up all their capital, or in a worse case, get stuck with losses that are unrecoverable. At the end of the day, as an investor, you must always be clear of your investment objectives and be aware of your tolerance level before making any investment decisions.
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