For years, I have emphasized that successful investors beat the market not by trying to “time it” but by owning individual stocks that outperform it.
I have also highlighted three of the best ways to earn better-than-average returns: momentum trading, value investing and riding the coattails of knowledgeable insiders.
But that covers only the buy side of the equation. To maximize your returns, you need to sell at the right time too.
If you don’t have a premeditated sell discipline – and the vast majority of investors don’t – you’re flying by the seat of your pants.
And that rarely leads to superior investment performance.
Longtime readers know that – with a few rare exceptions – we rely on trailing stops to do the job.
If you buy a stock at $20, for example, and you’re using a 25% trailing stop, you then immediately enter a sell stop at $15 with your broker.
As the stock rises, you raise your stop. When the stock gets to $30, for instance, your sell stop is $22.50. When it gets to $40, your stop is $30. And so on.
Do trailing stops really work?
Yes. They protect your profits and your trading capital. And there is more than just anecdotal evidence.
In a study published in The Journal of Portfolio Management, Christophe Faugère, Hany A. Shawky and David M. Smith – finance professors at the State University of New York at Albany – researched the performance of money managers who oversee pension funds, endowments and high net worth accounts.
Because most institutions work under strict investment guidelines, these academics were able to analyze performance based on different approaches to selling stocks.
The result? The institutional managers who fared best were those with restrictive rules that did not allow much leeway for hanging on to stocks for emotional reasons. The managers who relied on “flexible” sell strategies did far worse.
Count me unsurprised.
Institutional money managers are just as prone as individual investors to rationalizing when they make a mistake. (Hence the old Wall Street chestnut “What does a broker call a trade gone wrong? A long-term investment.”)
Adhering to a disciplined trailing stop strategy eliminates emotion-driven trading errors.
It cures greed. It overrides fear. And it does away with wishful thinking… as in “I hope this stock turns around and starts going the right way.”
Trailing stops, of course, are not the only effective sell discipline. But they’re one of the best and easiest to implement.
They make sure you never let a small loss become an unacceptable loss. And they keep you from selling stocks while they’re still in an uptrend.
One knock against this strategy is that unscrupulous market makers will sometimes take out your stop order right before a stock trades higher.
(Although this is sometimes more perception than reality.)
However, Richard Smith, founder of TradeStops – and Ph.D. in mathematics – has a service that provides an ingenious solution.
At TradeStops, you can enter the stocks you own, the price you paid and the percentage trailing stop you want to use.
If any of your stocks close beneath your selected stop, TradeStops sends a message – to your phone or email account – alerting you.
Some brokerage firms, like Fidelity, offer trailing stop alerts with their accounts. But they generally expire after 30 or 60 days. TradeStops’ information never expires.
It’s important to note that TradeStops notifies you, not your broker. It does not enter sell orders.
You can track up to 50 stocks at a time. (And whenever you stop out of one, you can replace it with another.) TradeStops even offers a 30-day, risk-free trial.
TradeStops is easy to use. It’s specifically designed for technophobes. And it’s reasonably priced.
The key is to make sure you have a predetermined point where you’d be willing to sell a stock that begins to underperform.
Of course, no sell strategy outperforms the luxury of hindsight. It will always be easy to look back and see what you should have done.
It’s more challenging when you have nothing but a blank slate ahead of you. And that’s always the case when you’re looking into the future.
Using trailing stops means you’re not just hoping that earnings grow and the market advances. You’ve taken out insurance in case anything goes awry.
It’s not for those who hope to increase their returns. It’s for those who want to guarantee it.
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