One of, if not the most, difficult things to do in investing and trading is deciding on when to sell. Whether it’s cutting a loss or taking a gain, this is when fear and greed really kick in. Buying is the easy part.
In prior posts, I’ve made references to my downside rules; they’re based on a pre-set % loss in either the individual stock or a comparable index, whichever happens first.
When it comes to taking gains, I set price targets and will adjust them as time goes on.
If my price target is hit, then I’ll sell. This is specific to stocks within the Top-Rated and Value (see http://ibankcoin.com/boyaj/2015/11/08/the-value-trap/) categories.
My price targets are calculated by averaging data points, including my projected enterprise multiple, Exodus, and other sources.
I can’t give away all my ingredients (extra 11 herbs & spices), but the absolute key is your thought process in finding your expected value and how margin of safety can be baked into your price target.
For those relatively new to investing, margin of safety is exactly what it sounds like: the delta between expected value (i.e., target price) of a stock and its market price. But how can you be sure you’ve provided yourself with “enough” safety?
This article, http://people.stern.nyu.edu/adamodar/pdfiles/eqnotes/marginofsafety.pdf, had a major influence on my perspective of price targets and margin of safety.
To best summarize and quote the author, “Margin of safety can be restated as a discount to expected value. Expected value is a function of the weighted probability of potential outcomes.”
For calculating my enterprise value multiple, this is exactly what I do. In a nutshell, using the EV multiples of comparable companies, I sum the outcome of the 1st quartile, median, and 3rd quartile multiplied by their respective probabilities. See pg 7 of the article for a functional example.
The complex objectivity comes into play when selecting their respective probabilities/potential outcomes. You must do your research and due diligence to feel comfortable enough to say that your target deserves more weight towards the higher or lower multiple.
Your target’s current products/services, market position, growth prospects, innovativeness, financial strength, management, etc. are all considerations for weighting.
Because the degree of difference between my price target/expected value and current market price is the margin of safety, the higher my margin of safety, the higher the position size in my portfolio. That’s the vital connection to all of this.
You allocate a large amount of your capital to a position you have confidence in because of the implied limited downside and higher upside. Many hedge funds managers imply this strategy; it’s one of Buffett’s trademarks.
While this post won’t tell you what to buy, it will give you an idea of when to take gains and a framework for making anticipatory tactical decisions as opposed to an emotional response.
If you enjoy the content at iBankCoin, please follow us on Twitter
the hardest part is selling…………….by far
@gametheorist, I appreciate your comments in my posts. How do you go about taking profits or cutting a loss? How do your rules/strategies differ for a stock that has a riskier profile? As I’ve said, my hope is to teach a little through my writing, but also generate discussion.