The Main Reasons Investors Lose Money
. . . and proven strategies you can adopt to
cut your losses and let your profits run
When US President George Bush ordered the invasion of Iraq in 2003 his father, George Bush, Sr., is reputed to have commented: “I hope he has an exit strategy.”
Bush did have one — but it was far from complete. He knew what he was going to do if everything went right. He and his advisers were so confident of success, they thought it totally unnecessary to have any contingency plans to cover what to do if something went wrong.
Well, we know what happened: just about everything you could imagine went completely haywire.
Bush was rather like the investor who buys the “rosy scenario” and piles into an investment. In his mind, he may have already spent the juicy profits he expected to make.
When things don’t pan out as he expected, he’s lost. And while he tries to figure out what to do, a small loss can rapidly turn into a giant one.
“The Small Profits, Big Losses Disease”
The “rosy scenario” investor usually suffers from what Harry Browne calls “The Small Profits, Big Losses Disease.”
When his investment shows a profit he gets excited — so he takes it. Often, though, his profit is a small part of what he’d have made if he had held on for longer.
When he incurs a loss, he hopes it’s merely a temporary dip. When it slides a bit more, he thinks to himself, “well, I’ll just wait till it gets back to my buying price. That way, I can get my money back.”
If it turns out it was just a correction and the investment starts rising, he sells out with a big sigh of relief . . . only to see it continue to zoom up.
But if his investment continues to fall, eventually he gets to the point where the only thing he can do to relieve his anguish is to sell. Often at or near the bottom.
The net result: a string of small profits offset by a series of much larger losses.
Alex, a friend of mine, suffered from “The Small Profits, Big Losses Disease.” He was heavily invested in dot-com stocks during the Internet boom.
He was a true believer. The mantra of that time — that profits didn’t matter any more — became his own. He was totally convinced that the Internet was going to change the world, and so — inevitably — his Internet stocks were going to make him a bundle of money.
The higher dot-com stocks went, the firmer his beliefs.
And what was Alex’s exit strategy?
He didn’t have one, just a vague idea that he was going to make a fortune.
And if his stocks went down what was he to do?
Buy more of course! They'd never be so cheap again. Borrow money on margin if necessary — which is exactly what he did.
So when the dot-com boom was followed, in 2000, by the dot-com crash, what happened to Alex?
At first he saw it as an opportunity to load up with bargains. But pretty soon his broker was knocking at the door with a margin call.
This wasn’t a “collapse” — it couldn’t be! Just a rather large “correction.” Inevitably (his beliefs told him) the dot-com stocks would recover and move to far greater heights.
Alex was sure he just had to hold on to as much as he could and ride out the storm.
To put things in perspective, at the top of the boom his original investment of $400,000 was worth close to a million. He had taken some small profits along the way, mainly when he had to sell something to buy a new “hot” stock — “hot,” according to his broker or some “guru” on CNBC.
So he had made several small profits. But as the dot-com crash unfolded, he kept getting more margin calls and kept having to sell more stocks to pay them. In the end his account had shrunk to $200,000, just half his original stake.
Alex believed that he knew what the market was going to do. (I call this “fundamentalist” approach to the market one of the Seven Deadly Investment Sins.) So — like George W. Bush — he planned for no contingency but success.
No matter how hard I tried, I simply couldn’t get Alex to admit, even as a hypothetical possibility, that he might be wrong. When I started talking about the importance of having an exit strategy, he’d simply shut his ears.
Alex now realizes that markets tend to follow Murphy’s Law: if something can go wrong, it will go wrong. Bitter experience has taught him that unless he’s prepared for the worst, he’s bound to lose money.
Today, he always analyzes the factors that will cause him to sell an investment before he buys it. As a result, he’s making money in the markets — and keeping it. He’s learnt the true meaning of the saying . . .
“Cut Your Losses, Let Your Profits Run”
As one seasoned trader put it:
“Don’t worry about what the market’s going to do. Worry about what you’re going to do if the market gets there.”
Which is all any of us have the power to control: how we will act in a given situation.
And when the market gets there — and “there” is not where we expected to be — which investor do you think will come out ahead: the one who has thought about what could go wrong, or the one who hasn’t?
It’s the investor who is fully prepared who ends up making the most money — because he loses the least.
Like Warren Buffett and George Soros, the world’s richest investors: they never make an investment without knowing exactly what factors will cause them to get out.
Whether with a profit or a loss.
So when something does go wrong, they already know exactly what they are going to do.
And this is the real meaning of the oft-repeated advice: “cut your losses, let your profits run.” You can only follow that advice when you know how you’re going to react to anything the market throws at you.
In other words, when you have an exit strategy.
When to Take a Profit . . . or a Loss
Developing an exit strategy is not difficult, although it may be somewhat tedious. And while it’s not as exciting as drooling over the profits you expect to make, it’s the only way you can ensure that you do make money in the markets.
An exit strategy is comprised of two parts:
- What you are going to do if everything goes as you expect; and,
- What you are going to do if something goes wrong.
The first step is easy. After all, there are only a couple of ways that everything can go right.
“The chapter on Exit Strategies in Mark Tier’s
The Winning Investment Habits of Warren Buffett
is worth the price of the book all by itself”
—Mark Skousen, Editor, Forecasts & Strategies
Nevertheless, it’s important to imagine the circumstances under which you’ll take a profit. Only then will you be sure to recognize the time when (or if) it comes.
The second step is a lot less exciting — and takes much longer: there are almost an infinite number of things that can go wrong.
Indeed, if you’ve ever experienced a significant investment loss, remembering it — and thinking of how you’d prefer to have acted — is a great way to appreciate how an exit strategy can save you a bundle of money.
I’ll give you a personal example. I’d bought a stock because of its very high dividend. One day, the company announced its profits had taken a hit and it was cutting its dividend. Should I sell? I procrastinated.
Looking back, I realize I should have sold it straight away. After all, I’d bought it because of the high dividend. With that gone I no longer had any reason to keep it.
Now, I continually keep in mind the reasons why I made an investment in the first place. If one of those reasons — like the high dividend — disappears, I immediately know exactly what I have to do.
I suggest that the next time you make an investment, you spend some time thinking about all the possibilities, both good and bad; and for each one, imagine how you would like to act.
Unless you have a photographic memory like Warren Buffett, I strongly recommend that you write everything down.
Why? If something goes wrong six to twelve months down the line, you won’t have to wrack your brains trying to figure out what to do. You’ll just pull out your list and know.
With a fully-developed exit strategy, you don’t need to take any time out to stop and think. You can act immediately.
If you spend even half as much time thinking about getting out as you do about getting in, your investment results will improve dramatically.
Harness the Investment Genius of
Warren Buffett & George Soros
Discover the Mental Habits and Strategies that
made them the World’s Richest Investors
Warren Buffett and George Soros both started with nothing—and made billion-dollar fortunes solely by investing. Their investment strategies are total opposites—yet they religiously follow exactly the same mental habits and strategies.
Adopt these mental habits yourself and Revolutionize YOUR investment returns