http://blogs.forbes.com/investor/2011/05/23/mimic-buffett-lynch-and-oneil-with-rules-driven-investing/
O’Neil, Buffett, Lynch, Livermore and Loeb all strictly adhered to a rules-driven system of investing that led to their enormous success. Employing time-tested and proven systems, these legendary investors were able to avoid such emotional pitfalls as hope, fear, pride and greed, which can destroy a portfolio. They not only used rules when buying, but also when selling; which is all too often ignored, but crucial for preserving profits.
John Maynard Keynes once said, “markets can remain irrational a lot longer than you and I can remain solvent.” Too many investors refuse to accept this wisdom and unfortunately wait in vain for failing investments to recover. However, investors can safeguard themselves by establishing, and sticking to, a set of sell rules that will replace hope with sell discipline, and result in less losses of their hard-earned profit. Remember, a loss of 50% requires a 100% gain just to break even.
My core sell rule? As a growth investor who focuses on industry-leading companies with strong fundamentals, I will always cut my losses at no more than 8% below my purchase price. The basis of this rule is derived from our firm’s historical stock market studies. We thoroughly profiled the most winning stocks in history, and found that after breaking out of a sound chart pattern, leading stocks typically won’t correct more than 7% to 8%.
Once a stock has begun to show a profit, I start to look for abnormal behavior or weakness as a sign it is time for me to sell. Primarily, I am on the lookout for signs of distribution in the form of institutional selling. You can tell that institutions are selling shares if a stock’s price is falling on above average volume, or if the price action is churning (heavy volume without significant price advancement). Other signs of abnormal behavior can include: a stock making new highs on low volume, a stock repeatedly reversing off highs and/or closing near intraday lows, or when it begins breaking logical areas of support like key moving averages and uptrend lines. A stock in a healthy uptrend should be able to avoid most of these negative character traits.
Sell rules can also help you lock in profits before greed takes over, making you hold a stock too long. After I establish a position, I begin to take profits at 20%, even though the stock might very well continue to advance. By doing so, I avoid giving up my hard-earned gains and in the turbulence of today’s stock market, a 20% gain is certainly respectable. Also, stocks will typically consolidate after advancing 20% to 25%, so instead of waiting out the consolidation, I take advantage by reallocating my 20% profit to another stock that is breaking out from a consolidation period or base pattern.
Stocks often flash signs of abnormal exuberance just before the price tops. To help manage my winning positions more profitably, I am always looking for sell signals while the stock price is still moving up. If a stock undergoes more than 2 stock splits in a short amount of time, it may be running out of room to grow. Additionally, if the stock is exhibiting abnormally higher than average volume, or continues to advance until it is extended 70% to 100% above its 200-day moving average, it may be approaching the end of its run or running out of buyers, and it may be time to cash in my shares.
Establishing sell rules that are right for you and having the discipline to stick to them is important. But just as important is remaining a student of the market, and closely analyzing and studying your action. Whatever your style, there is likely a corresponding investment legend with sell rules suited to your approach. Learn from the greats by reading their books, and applying their sell rules to your own investing strategy. You might end up making modifications as you go, but by establishing a set of disciplined rules and removing emotions from the equation, you will have taken a quantum leap toward becoming a better investor.
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