When You are Wrong

The Inevitable - What to do when you're wrong

When you're working on a project in a corporate setting, you're always prompted by management to “bring it back to the original theme”. As traders, I think we sometimes lose sight of some of the most fundamental things we learned when we started up the learning curve. So, I thought I would “bring us back” to one of the most elementary, yet critical, themes in trading. No one invests correctly all the time. But, what do you do when you are wrong? Here are some ideas about what to do when you have a stock that you wish you didn't.

First and foremost, test your original hypothesis . When things haven't worked out like you originally planned, the first thing to do go back and revisit the reason you took the position in the first place. In some cases, it may involve you delving all the way back to your investment discipline. Other times, it is company specific. You're reason for buying the stock may be as simple as "the stock just broke resistance on heavy volume and the industry is strong”. But five weeks later, if your momentum play hasn't followed through, you need to go back and check whether your thesis came true. If the group went higher but your stock didn't, something is amiss. It happens. In this case, selling the stock is the only logical conclusion, even if it means a loss. If your original thesis is still believable and you think it's true, then you can justify taking the position and you should hold the stock. In fact, the lower prices may simply mean the stock is an even better opportunity than it once was.

Moving forward, don't be afraid to take a loss . Holding onto a stock because you just don't want to take a loss is one of the most common ways to lose even more. Yet, it is probably the most common thing you see people doing in everyday trading. We all hate to lose money. But the "I'm getting out of this dog just as soon as I hit break-even" attitude has neither a thesis, nor a timeframe. In fact, if you step away from that statement, you'll come to realize that's it is one of the dumbest things you've heard. If you're down ten percent in a stock and it “gets legs” to the upside, that's the time to hold on, not sell. In the end, discarding the loser and finding a better position is a faster way to get back to "break-even."

Next, realize that anything you hold is a buy . Holding a stock is the same as buying the stock, as far as the money in that stock is concerned. If you didn't hold the stock today, would you put the same amount of money in it today? If the answer is a resounding “no”, then sell out. As a trader, you have an opportunity cost for every dollar you put into a stock. If you didn't own that position, you could own another stock. Or, you could take your significant other out to a nice dinner with that money. Or, you could go watch the Florida Gators beat the UCLA Bruins in the national title game in Indianapolis . Well, you get my drift. It's not just a stock; it's your hard earned dollars. Truly ask yourself whether or not you would buy that stock in today's trading session. If not, then sell because you're missing opportunities in other things by tying your dollars up in that dog.

So, here's the one that absolutely KILLED people in the bear market. Don't let your trading position turn into a long-term investment because you refused to take the loss. Can you imagine what your portfolio would look like if you, or your investment manager had simply used liberal twenty percent stop losses on all those tech stocks you owned? I realize that doesn't apply to all of you. But, I guarantee the majority of you just thought to yourselves, “If only I had done that”. This is the worst, and most inexcusable, way to take a long-term investment in a stock. If the long-term story isn't in place, what are you holding this stock for? Even worse, if you find yourself researching the stock “ post-purchase” , it is harder to be decisive about what you learn. You naturally want to hear good news, and only good news. So, be sure you understand why you're buying a stock before you buy it. Moreover, know where your exits are before you hit the trade button.

Last, know how you will be exiting a stock before you take a position. This one isn't exclusive to the sell-side. You need to know what your sell strategy is going to be even if the trade works out exactly as planned. You'll never actually have a profit until you sell so knowing where to sell is as critical as where you buy. There are three things that must be considered when developing an exit strategy. First, decide how long you are willing to be in the trade from a time standpoint. Is this going to be a swing trade (several days to weeks), a position trade (several weeks to several months), or some other length of time? Second, decide how much risk you are willing to take. If you trade using William O'Neill's CANSLIM method, you won't take any losses bigger than 7-8%. If you're a long-term position trader, you may expand that number significantly. Third, decide your exit point to the upside. Where is overhead resistance? If the stock goes up, as I expect, where do I lock in profits? Exit strategies and other money management techniques can greatly enhance your trading. Most investors, especially new ones, tend to focus on how much they can make and don't consider the risk of the trade. In reality, risk should be the focus of any investment, not returns. Before you enter a trade, consider the three questions we discussed and set a point at which you will sell for a loss, and a point at which you will sell for a gain. In the end, this risk/reward scenario will help you pass on trades that don't offer enough upside per unit of risk and will also firm the most important aspect of your trading; your discipline.

In conclusion, let me say that the most important thing you can do when you make a mistake is learn from it. The only way to become a successful trader is to experience all the things we've outlined here. T hings don't always work out. Even Warren Buffett loses at times. The seasoned investor knows that and move on. Realize; just because a stock goes down doesn't mean it was a dumb investment. Heck, if you hit 60% of your trades but keep your sell discipline in place, you will do all-right in the market. All investments are risk/reward decisions, and sometimes the risk side is what wins out. In the end, there are two things I will tell you about stock. First, you should marry your significant other, not your stocks . Sell if it is the suitable thing to do. Second, stocks are like buses, there's always another one coming. If a trade doesn't work out the way you planned, sell and wait for the next bus.

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