Letting your profits run seems like such a simple concept in money management. In fact, many investors have a tendency to let their losses run instead, and therefore cut their profits. Why? It is easy to see a loss and say, “It will come back.” Actually taking the loss would admit we were wrong going against our psychological profile. Letting our profits run has the opposite emotion. We start thinking about what would happen if the market turns down and we give up the gain. Both runs on profits and losses are motivated by fear and greed.
Yesterday I discussed the use of stops in your portfolio to assist in the process of exiting positions at predetermined points relative to our risk tolerance. This is a sound discipline for both winning and losing positions. Building this discipline into our strategy of investing is vital to success.
If this is true then why do we have such a hard time letting our profits run? It may not be easy to admit we are wrong on a loss, but with a profit we should be more confident in the position to hold on and maximize the gain. Right? Many times when discussing investing with individuals I have found they have the same anxiety over holding winning positions as they do cutting their losses on losing ones. It is vitally important to understand your investment personality. If you fall into either or both of these run traps, you must learn to define a discipline to eliminate or mitigate these mistakes.
Most people lose money because of poor money management discipline. For example, we buy a stock and lose $1,000. On the next investment we try to make it up by increasing risk. Not good. This can be done by increasing the size of the position or buying a ‘cheaper’ stock that will make more money. Why take the additional risk? The simple explanation is the psychological feeling of “being due a win”. After all it only makes sense since the ‘odds’ are now in our favor. The reality is the odds never change, just our mindset. Increasing the size of our risk because we are due a win is not a disciplined strategy for investing.
After a string of losses investors develop fear which influences their discipline on the winners. For example, you take a position in XYZ and it moves up 5%. Instead of letting the profits run you cut you profit because you don’t want to give it back. Besides, you have been losing lately and it feels good to experience a gain. These actions are all signs of not having a disciplined strategy or approach to managing each position as well as your overall portfolio. Stops are one simple component, when used properly and with discipline, that can help you learn to manage your personality relative to your money.
These examples illustrate the impact of psychology on decision making. Decision making is about knowing what you want and putting yourself on a path to accomplish the goal. There is a quote on my desk to remind me of this simple fact, “It is at the point of decision your destiny is shaped.”
Currently, the market has moved off the August lows and is making a run at the April highs. The consensus from some are that the valuations are too high and we are due for a pullback. So far, the selling has not materialized. In fact, the trend has continued to the upside. There are others who believe we are in the early stages of a longer term uptrend for the markets. Both opinions are just that, opinions. The direction of the market is easy to see looking at any chart. What you can’t do is predict the future. What you can do is let your profits run and use a trailing stop to protect against the downside risk should the market reverse directions. Thus, the simple discipline of letting your profits run, should come with a footnote regardless of your opinion.
Learn your personality and develop a disciplined approach to managing your money.
Disclosure Statement: Jim Farrish is the Founder and Editor of SectorExchange.com and TheETFexchange.com as well as the CEO of Money Strategies, Inc., a Registered Investment Adviser with the SEC. The company and/or its clients may hold positions in the ETFs, mutual funds and/or index funds mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. Investors who are interested in money management services may visit the Money Strategies, Inc., web site.
Disclosure: no positions