I'd like to share a little story with you today. I've told this one before, so if you've heard it, please bear with me. But I think it's appropriate for today's issue...
A newlywed couple is on their honeymoon in Las Vegas.
They had a sensible budget for gambling: a thousand dollars. However, by the third night that money was gone.
When the husband settled into bed for the night, he noticed something on the dresser. It was a $5 chip that he decided to save as a souvenir earlier in the day as their gambling budget evaporated. Then, suddenly, a vision appeared in his mind's eye. The number 17. It had to be a sign.
The husband quickly threw on his hotel bathrobe and went downstairs to the roulette wheel. He placed the chip on number 17. Sure enough, the wheel hit 17 and the 35-1 bet paid $175.
He decided to let his winnings ride, and once again it landed on 17, paying $6,125. And so it went, again and again, until the lucky groom was about to wager $7.5 million. The pit boss intervenes, claiming the casino would not pay out the winnings on such a large bet should it hit 17 again. Unfazed, the groom goes down the street to a different casino. Again, he bet it all on 17 -- and once again it hit, paying more than $262 million. Ecstatic, he let his millions ride again -- only this time the wheel turns up 18.
After all this, the groom returns to his hotel room and gets into bed.
"Where were you?" his bride asked.
"How did you do?"
"Not bad. I lost five dollars."
That fictional story about the idea of mistakes we make with "mental accounting" comes from the book "Why Smart People Make Big Money Mistakes And How To Correct Them," by Gary Belsky and Thomas Gilovich.
My colleague Jimmy Butts and I have discussed this idea many times throughout the years. In short, studies have shown that most investors don't have the slightest idea what they're doing when it comes to selling a stock. They get out when they should stick around... They wait too long when they should cut and run...
It seems so simple, but when faced with the decision -- do I book a profit now or do I let this stock ride a little longer -- we often tend to freeze up.
The best solution is to have a set of clearly defined rules already in place before you even buy a stock in the first place.
Is The Bull Market Almost Over? Time To Sell???
A couple weeks ago, I told you about how my colleague Jimmy Butts issued a "dire warning" to his Maximum Profit subscribers about the market.
The last time this signal showed up, Jimmy and his subscribers moved 60% of their portfolio into cash -- avoiding a market correction. In short, his rigorously-tested system was telling him that cash flow levels of many companies were declining in a drastic way.
This week, I checked back in with Jimmy to ask what actions he's recommending his Maximum Profit subscribers take. And I can tell you that he is definitely making one concrete recommendation: set tighter stop-losses on your holdings.
We've written about this idea before. In this article, for example, Jimmy explains how cutting your losses short may be even more important than knowing when to buy.
As Jimmy said:
"Investors have a hard time controlling their emotions, which often leads to small losses turning into large ones. When a holding is down 25%, most investors tell themselves either that A) they're not going to take any action because they're in it for the long haul, or B) they'll sell once the price gets back to break-even. What usually ends up happening is that they become 'buy-and-fold' investors, or they continue to hold a losing stock for years, hoping for the day it gets back to even."
But as Jimmy always points out, hope isn't a strategy. That's why you need an exit plan to know when to book gains and get rid of losers. Indeed, studies show that it's often holding on to losers too long that causes individual investors to underperform the market.
As for Jimmy and his Maximum Profit subscribers, he says, "... our sell signal is clear: when a stock's relative strength (RS) rating drops below 70, or if we hit a trailing 30% stop-loss, we sell. No questions asked. Case closed."
I've spent time in the past detailing the role relative strength plays Jimmy's Maximum Profit system, so I won't get into too much detail on that in this issue. (But if you want to know more, go here.)
Instead, it's the idea of a trailing stop-loss I want to get into today.
You see, since the early days of its formation, Jimmy's system has used a trailing stop-loss. It's rarely been triggered, thanks in large part because the Maximum Profit system is a momentum-based system -- i.e. you're buying stocks that are already going up and are statistically probable to continue doing so. In fact, the average loss in the history of the system's closed positions is only 8%.
But like any system, it's not perfect. (If anyone in this industry claims otherwise, you should immediately flee in the opposite direction.)
That's why, as a matter of precaution, Jimmy and his subscribers have a hard-and-fast rule to sell any stock that drops 30% from its previous high -- no matter what. It's a conscious decision on their part that they absolutely will not tolerate -- under any circumstances -- a loss of that magnitude sitting in their portfolio.
But now, Jimmy tells me he's recommending to his readers that they tighten up that rule -- to 15%.
There are a few reasons for this...
For one thing, as I explained a couple weeks ago, the system is starting to flash some warning signs about the market -- meaning we could be headed for a pullback or full-blown correction soon.
For another, let's face it... this has been an incredible bull market lately. Jimmy's portfolio, for example, is sitting on some fantastic gains right now (we're talking about gains of 26%, 54%, even 81% in less than a year). And if you're not sitting on gains like this, then you're really missing out.
That said, it would be a shame to see a chunk of those gains evaporate in a market correction. That's why the 15% stop-loss can be a good tool for harvesting gains, too.
Start Battening Down The Hatches Today
Bottom line, this bull market isn't going to last forever. Aside from Jimmy's concerns about cash flow, there are other signs starting to crop up (remember last week's interview with Jared Levy, where he discussed how he thinks the weakness in small-cap stocks could be another canary in the coal mine).
I'm going to touch more on some of the market's warning signs in subsequent issues. But right now, if you don't already have some sort of stop-loss rule in place, you should be thinking about one.
Better yet, why not let the best-performing rules-based system in StreetAuthority's history help do the work for you?
If you give Maximum Profit a risk-free trial, you'll not only get access to Jimmy's latest analysis, portfolio picks and their Maximum Profit scores, you'll also have the chance to take advantage of his newest complimentary service... Where you can regularly send Jimmy the names and ticker symbols of stocks you already own, and he'll run them through the system and score them for you.
That way, you'll know exactly where you stand with the stocks you own in your portfolio TODAY. For those who find themselves looking at their portfolio and wondering whether to hold on tight or whether to sell, I can't think of a better way of knowing.
This article originally appeared on StreetAuthority.