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
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