Please note - this is not a missive to advise you to sell all your stocks. If you read my thoughts on the taper yesterday, you'll know that I believe any selloff on taper fears is a buying opportunity.
Today we're going to talk about the "art of selling." No, not the Donald Trump art of "selling" - I'm referring to the art of selling your stocks at the right point to maximize profits and minimize losses.
Trading is about honesty. It's about finding the truth within ourselves through a constant process that forces you to make difficult decisions about your future. You are deciding on your future because the decisions you make as a trader impact your lifestyle.
The main difference between a losing trader and a "master of the universe" is that the winning trader is skilled at knowing how (and when) to sell for a loss or a gain. In the same way expert poker players know when to hold'em or when to fold'em. I don't believe this to be an innate skill, but can be learned by anyone with plenty of practice and a willingness to change their approach.
For now, let's focus on taking losses…
The importance of taking a loss and moving on is neatly summed up by trading legend Larry Livermore in "Reminiscences of a Stock Operator…
Losing money is the least of my troubles. A loss never troubles me after I take it. I forget it overnight. But being wrong - not taking the loss - that is what does the damage to the pocket book and to the soul.
As price starts to decline, rationalizing starts to increase, and the "troubles" compound into worse problems. And that's why it's psychologically more difficult to sell for a large loss rather than a small one. Bad traders will continue telling themselves, "Well, I held for this long. Might as well see it through now."
Bad traders are not only unable to see the truth, but also afraid to face it. They begin to justify price action and hope that the stock miraculously comes back.
My old boss at Salomon Brother once told me, "If you feel yourself hoping the trade comes back in your favor, immediately sell half." Hope is a trader's worst enemy.
Selling early and often for a loss will leave you in a better position to make better decisions. If you're holding and hoping, you are allowing emotion to overcome your decision-making process. Stop making excuses for bad behaviors.
Another understanding of why selling for a loss can be difficult comes from BF Skinner's work on positive reinforcement. We buy something, it goes higher, and you get a reward for holding. If investors are rewarded for holding, they are more likely to try and hold again in another trade.
Let's look at how this applies to stocks…
This is a 2 year chart of AAPL. You can see on the left side of this chart how AAPL went straight up from $400 to $650. Investors were rewarded for holding.
Now look at how much longer the selloff back to $400 took. Buyers of AAPL didn't give up hoping that the stock would return to $700 because they were so heavily rewarded on the way up. They rationalized price action on the way down, in lieu of observing stop-losses. This led to a longer drawn-out period of sell-offs and bounces.