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2011-07-19 12:29:39
Who needs a profit/loss plan? Isn't investing only about buying low and selling high? It would be nice to always buy at the bottom and sell at the top, but it is nearly impossible to do so consistently. Furthermore, investors are only human: emotions sway our judgment and it is in our nature to hate losing. Taking a loss on a stock, therefore, is not only detrimental to our pocketbooks, but it also hurts our egos. Time and time again investors take profits by selling an investment that has appreciated, but hold onto declining stocks in the hope of a rebound; oftentimes these investments shrivels to a fraction of their previous worth.
So how can an investor avoid this type of outcome? One solution is to learn to be a disciplined investor and to adopt a profit/loss plan. In this article, we'll go over this strategy and show you how to use it to stay in the black.
What Is a Profit/Loss Plan?
This plan is a step that many retail investors (and professionals) often overlook. The profit/loss plan is a set of limits that determines the maximum loss or gain an investor will take on a stock. Containing losses is a very important part of investing, so the profit/loss plan is crucial to a sound strategy.
We all make stock-picking mistakes and most of us have lost money in the stock market - what sets the great investors apart is their ability to recognize their bad choices and use what they've learned to make up for them later. A profit/loss plan helps you recognize your mistakes by allowing you to separate your emotions from investing. If you aren't too zealous about your gains and you see them purely as a means of increasing your cash flows (rather than your ego), you will have a much easier time letting go of your losses and, therefore, controlling them.
Devising Your Plan
Devising a plan may be more difficult than you'd expect. First, you'll need to set the maximum gain you will accept and the maximum loss you will tolerate for your investments, but these maximums and minimums shouldn't necessarily be the same for every stock. For example, a blue chip stock is more unlikely to rise or fall by 10% within any given year as compared to a small-cap growth stock, which will exhibit more volatility. In other words, you must analyze each stock individually to estimate how much it is likely to move in either direction.
Some investors use technical or fundamental analysis or a combination of both to determine appropriate limits for gains and losses. (For an introduction to "technimental analysis", see the article Charting Your Way to Better Returns.) Another way to devise your limits is by modeling your plan on the performance of a designated benchmark such as an index or even on the past performance of your own portfolio.
Another factor you must consider when devising your profit/loss plan is your risk tolerance, which depends on many factors such as your personality, your time frame and your available capital. Typically, people who are risk averse will have tighter boundaries than those who don't mind risk. Risk lovers will try to profit as much as possible from a rising stock, but a more conservative investor may sell the stock early on in its rise to eliminate the risk of losses, which would occur if the stock took a quick downward dive. If you prefer to shy away from risks, a profit/loss plan of 10% each way may not be suitable or even realistic for you. On the other hand, if you are willing to take on the added risks associated with potential profits, then a 10% profit/loss might be more appropriate.
Carrying Out Your Plan
Once you've decided on your numbers, whether conservative or aggressive, you have to put the plan into action with as few hitches as possible. Remember, this plan has a double requirement: you have to sell your stocks (1) if they fall to a certain level and (2) if they rise to a certain level.
Now, brokers will not let you enter two different sell orders for the same security so you need to figure out which one you'd rather enter first. It may be wisest to enter orders that first protect your downside: many wise investors use the stop-loss order, which instructs your broker to buy or sell a stock once it has reached a certain price. The stop loss ensures that you won't get burned on a down market, especially if you aren't able to watch your stocks every second. When you enter in your order with your broker, set the stop price at your maximum loss percentage and then sit and wait. If the price ends up appreciating to your upper boundary, just change the price of your stop loss order, which will then activate the immediate sale of your stock.
Staying Disciplined
Once you have your profit/loss strategy in place, you will have to remember that the whole idea of the plan is to establish strict guidelines for when to sell. Sure, it hurts to see a stock continue to rise once you have sold it, but it is often better to sell on the way up than to wait until you have to dump the stock while the price is collapsing after its peak. Joseph P. Kennedy, Sr. once said, "Only a fool holds out for the top dollar."
Conclusion
Keep in mind that our example figures are generalizations. Devising your plan requires detailed research, analysis, self-assessment and a realistic outlook. Setting a profit limit at 100% (double your money) doesn't make sense if you invest in low-risk companies that grow steadily at 15% per year.
Here are some things to remember:
A stock that declines 50% means you will need to double your money to get back to even. Controlling losses is the key to sound investing.
Making mistakes is human nature. Once you realize this, you will find it easier to move on.
Buying a stock and holding onto it for a very long time doesn't mean you will make money. A buy and hold strategy will work only if you pick the right companies.
The most important part of devising a profit/loss plan is sticking to it!
by Investopedia Staff
Investopedia.com believes that individuals can excel at managing their financial affairs. As such, we strive to provide free educational content and tools to empower individual investors, including thousands of original and objective articles and tutorials on a wide variety of financial topics.