The Importance of Exits & Managing Risk

Q4 2018 was a testing time for stock market participants as global equities plunged across the board and many AIM darlings (and non-darlings) were smashed to smithereens. The extensive and increased use of leverage has certainly amplified some of these moves, as ladders of stops are triggered, exacerbating what might only have been a move of a few per cent into a double-digit percentage drop. No doubt many (including myself) are wondering what they could have done better.

Everyone is great at buying shares

Of the many mistakes private investors make, having trouble buying shares is not one of them. Private investors are inherently long, and we know that humans are attracted to stories. A strong and romantic narrative, backed by a charming CEO, can often lead to us owning stock without having even done all of our usual checks. We then kick the tyres properly and realise we should probably sell, yet we rationalise it to ourselves as we don’t want to be wrong. Nobody ever has a problem buying, but people do have problems selling.

Entries are not as important

Traders often place emphasis on the entry of a trade. They think that if they have a high probability entry then the trade is likely to have a high probability of turning a profit. Not so. It is only the cumulative exits on the trades taken that will determine a trader’s probability. Nobody ever went broke not entering trades, but they did go broke by stubbornly not selling when they should.

When investing, we tend to think that we will sell the shares when they the business is starting to slump or become fully or richly valued, or when we find another investment more compelling. This is great if this is the plan and it is a plan investors stick to, but how many have thought about how they would feel if they saw the value of their investment halve? Amazon lost nearly 70% of its market value once, and has had several 30%+ retracements from the high. It takes serious conviction to hold through such a testing time, and no doubt there are few investors left (if any) who are still holding Amazon from its IPO over twenty years ago.

Fear, shock and panic selling

Two weeks ago market darling Fevertree was smashed from 3600p and reached an intraday low of 2462p. Those investors who loved it at 4100p a few weeks ago surely loved it even more? Fundamentally, nothing had changed in the business, only the stock market’s perception of the business. It was still shipping tonic water and ginger beer across the UK, and people still loved it drinking it. Only you could buy the stock a lot cheaper! The problem is, investors don’t consume the product. They consume the stock, and they can only sell that stock to other investors. Some of these investors will have gone through the classic cycle before selling – unnerved feeling, discomfort, shock, pain, before deciding the pain is too much and puking (whenever I’ve done this I see the stock immediately reverse –typical). This is never nice, and the only real way to prevent this from happening again is to have a plan.

Contingency planning

I learned about contingency plans from Mark Minervini (you can buy his books here INSERT LINK TO WHEELIE BOOKSHOP) here, and this jumpstarted my trading. It sounds obvious to have a plan, and yet I wasn’t doing it. Not only for exits – for everything. What do you do if your internet doesn’t work, and you have no access to internet on a laptop? He suggests to list every single thing that can go wrong, and then put in a plan in place to act upon. One day my internet broke in my apartment, I couldn’t reach anyone to fix it, and there was only half an hour to the open. Luckily, I already knew that none of the cafes where I lived had any internet (Germans don’t like Wifi), and so I didn’t waste any of my time and went straight to Starbucks. This was the same day the spoofy article on Electric Jukebox listing at £20m was released, and YOLO bagged. Had I not known what to do I would’ve missed this trade.

Checklists

As humans we are not programmed traders. Our fight or flight instinct pushes us to do the wrong thing; we are hardwired to follow the herd and not go against the crowd. Emotions have no place in the stock market, and those who cannot discipline themselves will be punished. To remove as much emotion as possible, checklists are a very useful tool in order to ensure you stick to your plan.

Exiting

If we don’t have a plan in place to sell, or even a profit target, this means we will only ever sell in a state of distress or panic. We will never sell on our terms.  As the price goes up, we feel justified in being correct and because we’re investors we’re happy to watch it rise. The stock keeps going up, and complacency sets in.  We have no exit plan, then one day the stock dumps, we don’t know what to do, and we make purely emotional decisions as we look at the percentage move that we’ve not taken from the table. This was a mistake that cost me dearly, and not one I wish to repeat.

Should you sell some and de-risk when you’ve made 50%, 100%, 200% of your money? Should you sell when management ‘invest in margins’ or growth is slowing down? Should you sell if the 200 EMA is breached? The only way to sell on your terms is to create a plan and then do your absolutel best to resolutely follow that plan.

Entries

Though exits are far more important we can improve the quality of our exits just by following our plan. If you take a punt (we’ve all done it), it’s unlikely that trade does not fit with your criteria and you are more likely to take an unnecessary small or even a big loss. Trading is not a point scoring game but one of eliminating errors; if we don’t take poopflute punts these won’t show up in our exits.

Before entering a trade I like to plan the exit before I put the trade on. I am prone to human error so sometimes do not do this, but getting into this habit and having a risk-first focus will limit your mistakes. Thinking about how much you can lose, rather than how much you can win, will ensure that your drawdowns stay minimal.

Automation is key

The best way to remove emotion is to plan after the market has closed where no flashing lights or Level 2 screens can distract you. Some of the best trades can be made having fast fingers and jumping on news, but without training yourself to know when to accept a trade has gone wrong this can blow up quickly (especially when trading on margin).

Once I had a stock in my portfolio that kept going down, and I kept holding it. When I asked myself what this company was doing there, I couldn’t give myself a reasonable answer. I ended up selling for a needless loss – if I had questioned my positions on a nightly basis this stock would have been gone a long time ago and saved me a nice bit of cash.

System improvement

The best way to improve our exits is to improve our entire system. Better entries lead to potential better exits. Better exits lead to more cash. More cash leads to more potential entries. The only real way to improve our system is to increase our ideas, test them out, and do what works. I am not smart enough to predict what will happen to the stock market, so I’ll leave that to the clever people, but markets rise and fall based on greed and fear. It’s up to us to navigate the storm and protect our portfolio.

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