How the World’s Best Investors Get Out of Their Own Way

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BY KEITH KAPLAN
CEO, TRADESMITH

I can say with 100% certainty that YOU are an emotional being.

And you’re not alone. I can be emotional, too. We all can… and it’s only natural in certain situations.

But if you’re making emotional decisions about your investments, it’s almost certainly costing you money.

You see, I believe most investors are actually pretty great at picking stocks. But they’re still terrible investors. In the past, I would’ve said that about myself, too. (And I had the track record to prove it.)

Just think about this for a minute…

When you buy a great stock, how do you decide when you’ll sell it? If you’re like most folks, you probably don’t give it much thought.

But this isn’t the type of decision you want to leave up to your “gut.” When it comes to investing, you must have a clear “exit strategy” for every investment you own.

This is what separates the masses of investors who match or underperform the market… and the rare few who beat it every single year.

Today, I’ll show you an exit strategy that’s been working for me and TradeSmith readers for many years.

Through the Financial Crisis of 2008, the COVID meltdown (and recovery), and whatever may come next, this strategy never fails.

It’s something the world’s best investors use consistently to “get out of their own way” and listen to reason rather than emotions.

And it’s something you can start implementing in the next 10 minutes after you finish reading this email…

Stop Losses: The Emotion Eraser

Here at TradeSmith, we love using stop losses.

A stop loss is simply the price at which you decide to sell an investment below its current price. When you set a stop in your brokerage account, you’re putting in an advance order to sell automatically at that pre-determined price and minimize losses.

But even more powerful is the trailing stop loss.

With trailing stops, as the price of an investment rises, the stop price “trails” or follows it higher. But if the price falls, the stop price stays the same. It never moves lower.

Say you bought a share of ABC stock at $10. You set your trailing stop at 20% below its closing price.

Then, the stock doubles to $20. That means your exit plan is no longer $8… but $16.

If or when your investment closes below the trailing stop price, you simply sell and wait for signs of a new uptrend before getting back in.

This means trailing stops can not only protect you from big losses in your worst-performing investments, but they can also help you “lock in” gains and realize even bigger returns from your winners.

This simple strategy erases all the emotions from your investing strategy, so you can sleep well at night.

In other words, trailing stops are about as close to the “perfect” exit strategy as you’re likely to find. And we personally use and recommend them for just about every public-market investment out there, including individual stocks, exchange-traded funds (ETFs), most stock and bond mutual funds, and even options.

The only issue with this is one size doesn’t fit all. Volatile stocks, like Tesla (TSLA) for example, are much more prone to dropping 20% than something like, say, Johnson & Johnson (JNJ).

But if you sold TSLA whenever it fell 20% and bought back in whenever it formed a new uptrend, you’d be in and out of the stock constantly. It’s a headache… and a bad investment plan.

So here at TradeSmith, we decided to take this risk management technique a big step further.

How TradeSmith Perfected the Trailing Stop

Here at TradeSmith, we recommend our readers use a different kind of trailing stop to make sure they stay in great, if volatile positions… and cut losses that are unusually large, which could lead to prolonged downtrends.

This comes down to what we call the Volatility Quotient or “VQ” – of each individual stock.

The VQ is a proprietary metric we’ve developed that considers each stock’s individual behavior before recommending a stop.

It’s easiest to show you how it works with an example.

Back in 2016 – before I joined TradeSmith and long before I became its CEO and the investor I am today – I bought stock in a company you might have heard of called Advanced Micro Devices (AMD).

I thought the market had mispriced the stock and I was convinced it would quickly head much higher.

That’s not what happened. It went up a little, then it went down a lot more. I immediately began to second-guess my decision.

And when it finally bounced back to near my entry price, I gave up and sold my shares for a small 3.5% loss.

A small loss is certainly better than a big one. It could’ve been worse.

But it turns out if I had done absolutely nothing different except use a 25% trailing stop on that stock, the outcome would’ve been much different.

Instead of selling for a 3.5% loss, I would’ve held on for a 48% gain less than one year later.

That’s a HUGE improvement. And even better, I could’ve avoided the emotional rollercoaster that had led me to sell those shares too soon in the first place.

But watch this.

If I had used a TradeSmith VQ-based trailing stop instead of a 25% trailing stop, I’d have exited in the spring of 2022 for a 1,300% gain.

AMD’s VQ, as I write, is at 39.95%. That means if you bought AMD today, you should set a trailing stop at that level – no more, no less.

That might sound like a steep potential loss. And it would be.

But AMD is the kind of stock that has this level of inherent volatility. And if you sell too early during a drawdown, you risk missing out on many years of bigger gains.

This is why I say TradeSmith “perfected” the trailing stop. While the basic 25% at least keeps you from exiting on an emotional reaction instead… my AMD position is a great example of why it pays to have the right software.

How the World’s Best Investors Get Out of Their Own Way