Chapter 2: Things to Avoid
Building upon the last chapter, we are now ready to explore and face the mistakes that nearly every beginning investor makes. Do not skip over this or any other part of the book because you need to be aware of these mistakes. Otherwise, you may spend years learning these lessons the hard way. Practicing these errors versus not practicing them makes a very large difference in your rate of return, not just a small difference. Generally, in fact, it will make the difference between a large positive rate of return and a large negative rate of return.
Obviously, there is a relationship between the investor myths of the last chapter and the errors reviewed here. Each of these mistakes is traceable to the myths. As was said earlier in the book, if you are to change your investment results, you must first change your thinking. If you have read and understood what's been written so far, you are well on your way to doing this.
Mistake #1: Not having an exit plan before buying
No matter how well or poorly founded, every stock selection strategy produces both losers and winners. In the case of both losers and winners, the reason for selling a stock is always the same: To preserve capital and allow you to re-deploy it to more profitable investments. The relevant question is, "how to determine the right time to sell?"
The time when you can think most clearly about why you would eventually sell a stock is before it is purchased. Before you buy anything, you have no emotional attachment to it, which means you can make totally rational decisions. Once you own something, you tend to get either greedy or scared. These emotions lead to a desire to preserve profits, leading to prematurely cutting off an ascending price trend.
How not having an exit plan hurts your performance
Big losses are one thing which destroys most investor's performance, and these are almost always a direct result of the investor failing to plan, before entering a trade, how he will exit it. Since the potential gains from a stock are always higher than the potential losses (100% loss potential versus unlimited upside potential), an even bigger source of under-performance is selling too soon when you do find a great winner.
An exit plan is one thing that experienced investors/traders always have before initiating a position. The reason is simple: you must have a plan and stick to it, or else every decision you make will be emotional, not rational. Worse yet, the larger the position is, the less rational your decision-making will be. Therefore it is vital to make all decisions up front, before you are scared (if the position happens to go down), or greedy (if it soars). Emotional decisions almost always are poor ones, leading to large losses and small gains.
The pitfalls of trying to manage a stock portfolio without a plan are many and varied. The advice of friends, stockbrokers, market advisors, and the like are all likely to have a magnifying effect on the natural elements of fear and greed that are present in every investor. These influences can cause someone who does not have a well-thought-out plan to abandon profitable positions and hang on to losing ones. This is exactly why the majority of amateur investors under-perform the market: they do not have a plan. As the saying goes, "when you fail to plan, you plan to fail." This saying is as true in the stock market as it is in any other aspect of life.
With emotions running rampant from a loss or a large gain, it is virtually impossible to make a good decision. This is precisely the point at which most investors fail: They have no preconceived plan for exiting a stock before they buy it. As a result, when they hear a tip or rumor on a stock they get so excited that they forget to ask themselves what they will do if it turns sour, or if it soars, what will be their plan for letting the profit ride? If the investor who doesn't plan ahead also happens to believe some of the myths presented in Chapter 1 then his/her chances of making a good decision are almost nil. If you are a decision-maker of any kind, you no doubt realize that making decisions based on wrong assumptions renders your chances of success to be miniscule. For this reason, the need for an exit plan based on sound theory before a stock purchase cannot be overemphasized. Unfortunately, most investors don't want to think about planning ahead, (especially for adverse possibilities) when they are buying a stock - they put the selling criteria decision off until it is unavoidable, and usually too late.
An exit plan must be identified for every investment before the investment is made. This plan should cover all possible outcomes of the trade, both profit and loss.