Are you a trader or an investor? The difference is frequently discerned by how closely you monitor the stock market and how quickly you move in and out of investments. Traders are often referred to as “market timers” because they actively seek to buy into positions when share prices drop and sell out when those prices rise.
Many financial planners and professional money managers are not strong proponents of market timing. The reality is that no one can predict market movements accurately over the long term, so success is often a matter of luck and opportunity.
However, market timing is not the same as having a carefully structured and disciplined investment exit strategy. One reason this is important is that it can help prevent investors from panic selling. If you have considered the growth potential and market risks of a particular security or type of investment and you put parameters in place that reflects your comfort level, then you can control your losses to a great extent. Without this analysis, you may be subject to emotional responses and sell for a significant loss because you can’t take the stress of watching your investment lose money day after day.
When share prices drop unexpectedly – and continue to fall – many investors let their emotions get the best of them and sell prematurely. Having a preconceived exit strategy is a good way to prevent this type of panic selling.
An exit strategy means that you set a target sell price, but it’s important that you have the discipline to sell at that price. Often when a stock’s share price is rising quickly, it is tempting to “let it ride” and ignore your exit strategy. However, that tide could change quickly in the other direction, turning a profitable trade into a loss. When this happens, you may stubbornly hang on to that declining stock knowing that you missed your opportunity to cash in – and hope that it will come around again.
An effective exit strategy should have two plans in place: a price point to sell for a gain and a price point to sell for a loss. This tactic can help keep your asset allocation strategy on target by not letting gains or losses in any one position throw your target asset allocation percentages out of whack. At the same time, you can manage risk by not allowing your portfolio to lose too much money. Certain tactics can help implement your exit strategy. For example:
- Stop-Loss – an order to sell a security when its price is declining at the point when it reaches your assigned stop price (sell-stop).
- Stop-Limit – a limit order gives instructions to sell a stock at a minimum price point. Stop-limit orders can be set to expire at the end of the current market session or carried over to future trading sessions (GTC – good ‘til canceled).
- Trailing Stop – a modified stop order that can be set as either a percentage or dollar amount below or above the market price of a security.
An investor’s exit strategy should take into consideration potential taxes on capital gains. The amount you pay depends on how long you hold a position. If held for less than one year, the short-term capital gains tax rate is the same as your regular income tax. If held for one year or longer, the tax rate is 0 percent, 15 percent, or 20 percent – depending on income tax bracket and filing status. When determining your exit strategy, it is prudent to set a long-term perspective with a plan to harvest gains on positions more than a year old.
Setting up an exit strategy is one component of a risk management plan. The following are other complementary strategies you can deploy to set boundaries on how much money you are willing to lose.
- Risk/reward ratio – Set a minimum ratio. For example, 1:3 means you are willing to risk $100 for a potential profit of $300.
- 1 percent (or 2 percent) rule – Limit your risk to investing no more than 1 percent of your portfolio on any one trade.
- Diversification – Spreading your investments across a variety of assets in order to reduce portfolio losses.
Remember that investing is replete with uncertainty; not even the most experienced money managers can predict the direction of the markets. Developing an exit strategy for stock holdings is a way to minimize potential losses while strategically targeting specific returns to meet your goals.