Risk Management Strategies
These are some of the strategies that are mentioned in William J. O'Neil's book,
How to Make Money in Stocks.
It makes sense to have a DEFENSIVE plan to go along with your purchasing strategy.
Always try to learn from your past mistakes, and use these suggestions as a guideline.
The Red Dress
This is a favorite of O'Neil's examples on how to invest
in the stock market just like you would run a business. For a minute, let's suppose
you own a small retail women's clothing store. You have bought and stocked women's
dresses in three colors- yellow, green and red. The
red dresses are quickly sold out, the green ones are half sold, and none of the
yellow dresses have sold. What are you going to do?
Do you go to your buyer
and say, "The red dresses have sold out. The yellow ones don't seem to have any
demand, but I still think they're good and besides, yellow is my favorite color,
so let's buy some more of them anyway"?
No! The clever merchandiser who survives
in the retail business eyes his predicament objectively and says, "We sure made
a mistake. We'd better eliminate the yellow dresses. Mark them down 10%. Let's have
a sale. If they don't sell at that price, mark them down 20%. Get our money out
of those "old dogs" and put in more of the hot-moving red dresses that are in demand."
This is common sense in a retail business. Do you do this with your investments?
Why not? Do you have any specific selling rules, or are you just flying blindly?
The 7% - 8% Rule!
Seriously consider adopting a firm plan to limit the loss on each stock
you buy to a maximum of 7% - 8%. Once you are down to that point you should no longer
hesitate. You don't need any other reasons, because the simple fact that you are
down 7% - 8% is all the reason you need.
This is kind of like insurance.
You sell to make sure you don't suffer a catastrophic loss. Granted, there will
be times when the stock you sell will turn around and immediately go up. You will
probably get very perturbed and think you made the wrong decision if the stock rebounds.
Suppose you bought fire insurance on your house last year. Just because it didn't
burn down, are you upset because you made a bad financial decision? Fact is, you
don't buy fire insurance because you know your house is going to burn down. You
buy insurance just in case, to protect you from the remote possibility of a very
Some people have even damaged their health agonizing over declining
stocks they were holding. It is best to sell and stop the worrying. You have to
accomplish a very critical objective of keeping your losses small, even if a number
of the stocks move up after you sell them. Letting your losses run is the most serious
mistake made by almost all investors! If you aren't willing to cut short and take
your losses, you probably should not buy stocks. Would you drive a car down the
street without brakes? Probably not!
Investors are always hoping rather than being realistic. Everyone loves to buy
stocks; no one loves to sell stocks. As long as you hold a stock you have hope that
it might go up enough for you to get back even. Once you sell, you abandon all hope
and accept the cold reality of defeat. You can't afford to have a love affair with
A great trader once said, "There are only two emotions in the
market - hope and fear. The problem is we hope when we should fear and we fear when
we should hope."
Averaging down is usually not an effective strategy for
making money in the stock market. The fact is, in most cases, you should already
be out of the stock before you ever even reach the point where you're considering
averaging down your cost. Wouldn't it make more sense to buy a stock that is strongly
performing in the market, rather than more of one that has broken down? Usually
when a stock has dropped in price there is what is referred to as "overhead supply"
or, in other words, there are a group of people who bought it higher and many of
them are now looking to get out of it. These people view the stock as a "dog" and
are anxious to sell each time it gets back up to around the price they got into
it. It is only after the stock breaks through the overhead supply (resistance) that
it is likely to have a dramatic rise in price.
Plenty of people still will
insist that averaging down is a smart thing to do. You might want to be prepared
for a long wait, especially if the company has had a disappointing earnings report,
which is often the case when stocks have fallen off sharply.