Grinning like a Cheshire cat, Dave had one eye on his burgeoning pile of chips and another on me. It looked like a grand in clear winnings from where I was sitting.
"Bengt you're an idiot for not getting in on the system" I felt his eye blurt out.
He'd been on a tear. It was some new-fangled strategy he'd read about and it was romping home. A winning streak told Dave he should up the ante. And he did, with disastrous effect. Before long his carefully acquired chips were back where they belonged.
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"Idiot", you may well say. But many of us are more like Dave than we care to realise. The stock market is full of Daves: investors with an in-strategy, but completely missing the exit.
How the casino really makes its money
In theory, casinos make their money from the odds. On the roulette table there are 36 numbers and a green. If the marble lands on green, you lose. That's the casino's commission (1/37 = 2.7%). Seems reasonable right?
Well, that's not how a casino really makes its money. There's a human flaw that they're exploiting to a much greater effect.
When Dave starts an evening on a losing streak, his chips disappear and his evening finishes early. He reckons the gods aren't on his side, so he packs up and gravitates to the bar. While Dave's enjoying a pint, he misses the opportunity to win his money back should his luck change for the better.
Now, on evenings when Dave starts off well, he reckons his luck will run. So he ups the ante, his £5 bets increase to £10. But inevitably his luck changes for the worse. And because he's upped the ante, he quickly hands back his winnings. His 'on the hoof' strategy nearly always guides him to a loss.
Many investors too don't have a strategy for taking some chips off the table.
So what's your exit strategy?
Paper profits aren't real profits until they're realised - just look at all the paper millionaires spawned during the dotcom fever. When you cash in your chips or sell your shares, you can book the profit. But never before.
In my experience, investors don't give enough thought to exiting a trade. And yet, whether you're winning or losing, it's probably the most important decision you'll make. It's even more important than picking the stock in the first place!
Have an exit plan and stick to it
There are two main exit routes.
First, there's the valuation route. Using the company accounts, you use the fundamentals to assess whether the business is still a buy. It could be something like the P/E ratio. Say you buy a stock at 8x earnings and it goes up until it's trading at 12x earnings
You tell yourself: This isn't cheap anymore. I wouldn't buy this stock today, so I'm selling.
Secondly, there's technical analysis, or charting. So if a stock rises, or falls by a certain percentage, you cash out. There are loads of different charting strategies and you can even make your own up.
The important thing is to set out your strategy before you even open the trade. That way you won't allow emotion to override the logic of why you put your money down in the first place.
If you don't know what your exit strategy is, then you haven't got one. At the casino, Dave plays with money he can (and does) lose. Don't let your investment portfolio suffer the same fate.
This article was written for the free investment email The Right Side. Sign up to The Right Side here .
Your capital is at risk when you invest in shares - you can lose some or all of your money, so never risk more than you can afford to lose. Always seek personal advice if you are unsure about the suitability of any investment. Past performance and forecasts are not reliable indicators of future results. Commissions, fees and other charges can reduce returns from investments. Profits from share dealing are a form of income and subject to taxation. Tax treatment depends on individual circumstances and may be subject to change in the future. Please note that there will be no follow up to recommendations in The Right Side.
Managing Editor: Theo Casey. The Right Side is issued by MoneyWeek Ltd. MoneyWeek Ltd is authorised and regulated by the Financial Services Authority. FSA No 509798. https://www.fsa.gov.uk/register/home.do
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