“The investor’s chief problem—and his worst enemy—is likely to be himself. In the end, how your investments behave is much less important than how you behave.” - Benjamin Graham
Traditional economists consider humans as rational beings, but, in fact, we aren’t! And this isn't trash talk, it is actually a fact. The ‘disposition effect’ in behavioural finance states that the fear of recording a loss is so high in the investor community that these money-makers often offload the winning stocks too soon under the fear of them turning into a loss-making investment. On the other hand, they keep betting crazily on loss-making stocks with the hope of them turning into a profit-making call.
It’s evident that we humans are profoundly wired to ‘loss aversion which is also a reason for us not being able to exit investments at the right time. Now you must be wondering- “But aren’t these fears real? How can we know when is the right time to sell a stock?”Read on and we’ll help you understand the importance of an exit strategy as well as how you can go about planning it.
Importance of an Exit Strategy
According to the great American investor, Peter Lynch “People who succeed in the stock market also accept periodic losses, setbacks, and unexpected occurrences. Calamitous drops do not scare them out of the game.”
When you have skin in the game, there is a high chance of it getting bruised or even ripped apart, but if you start giving up every time it happens, you won’t just lose a game, rather you will lose out on the entire journey that you have travelled until now. Losing just a small amount of money or getting bruised is fine, it happens to every investor, but what makes them great investors is the quality of sticking to the great stocks and embracing losses as happily as they would have celebrated the gains.
When a rookie enters the stock market as an investor, the very first teaching they get is of analysing the financial statements and financial ratios according to which, the time of entry is planned. However, in this tedious task, an amateur often fails to plan an answer for 'What am I going to do if this doesn’t go my way?’
Well, this is where an exit strategy enters the show. The significance of exit strategy is as follows:
It prevents investors from reacting emotionally towards a stock.
It minimizes the risk of downfall and capital erosion.
It maximises the potential of gains.
It directs an investor towards better opportunities.
How to plan and execute the exit strategy?
“Without a strategy, execution is aimless. Without execution, strategy is useless.” - Morris Chang, CEO of TSMC.
Now that you know the significance of having an exit strategy, the next step is to learn how to formulate and execute the liquidation mechanism. As we start with chalking out an exit strategy, the very first step in this process is to breakdown your investment strategy into the following components:
Investment Horizon
Investment Objective
Threshold Rate
Target Rate
Let’s understand...
1. How long do you want to stay invested?
Investment horizon is a financial planning parameter that refers to the period of time an investor is willing to hold the specific portfolio.
It is important to have an investment horizon for all the securities based on the substantiality of return generation, according to the research and analysis of the company. This helps in eliminating emotional reactions to a stock, which eventually leads to disciplined investing and minimizes the impact of loss averse attitude.
2. What do you want to achieve with this investment?
Investment objective helps an investor in knowing the purpose of a particular investment. It is one of the crucial considerations in formulating an exit strategy as well as an entire investing strategy of an investor.
The investment objective can be divided into three categories and can be listed down in a matrix presented in the next section(after a while). An investor must sell their holdings once the investment objective is fulfilled.
3. How much return are you expecting?
Once an investor has completed his/her research, they must assign a value to the parameter of target rate which is the expected rate of return from an investment. The setting of targets must be research-backed and must be in accordance with the trends in the industry and in the economy as a whole.
Having a target rate helps an investor in exiting the investment as and when the target is achieved, which in turn, saves them from sentimental calls and ensures a disciplined approach.
4. What will you do if you get or don’t get what you expected?
Let’s say you are sitting in a class where your friend punches you once, twice and thrice but you take it in a friendly way and therefore you don’t react to the pain caused by physical humour. But as soon as he lands the fourth punch on your belly, you go completely out of your mind and now you know what follows.
Basically, your tolerance level to a particular thing is what the threshold rate is. It is the point beyond which an investor needs to react to their investments.
For example, If you have set a target rate of 10% then you can probably set a threshold rate for loss as well as for profit-making situations. Therefore, if your return goes beyond 12%, you need to check the sustainability of such high returns and if you are satisfied with it, you can continue with the investment. But, if your research begs to differ, then you must exit the investment.
*Tip: Setting limits, triggers & stop losses will come in handy.
A framework for an exit strategy
As we discussed, this kind of a planned matrix can help you make exit decisions with more conviction -
INVESTMENT HORIZON | INVESTMENT OBJECTIVE | NAME OF SECURITY | TARGET RATE OF RETURN | THRESHOLD RATE OF RETURN |
LONG TERM (10 YEARS) | *** | *** | *** | *** |
MIDTERM (5 YEARS) | *** | *** | *** | *** |
SHORT TERM (2 YEARS) | *** | *** | *** | *** |
Useful tools for an exit strategy
Just wanting to get out of holding an investment instrument is not enough. There needs to be a proper, planned approach to it; or investors can either hold on to loss-making instruments or sell potential earners prematurely. Following are a few ways investors can safely sell investments for ideal results.
Limit Orders
It is a brokerage facility that allows a person to set a target price for the stock investment. Limit orders help in exit strategy as a stock gets automatically sold if the target price is reached in the market.
Suppose, if you bought a stock at Rs.100 and set a target price of Rs.150. Then, the stock will automatically get sold off if the market price of the acquired stock hits Rs.150.
Stop-Loss Orders
This facility helps an investor to exit the investment automatically after a specified amount of loss. For example, if you place an order at Rs. 2400 with an anticipated downside or the stop loss value of Rs. 2350, the security will be automatically sold off if the market price of the specified stock hits Rs. 2350 and will stop the further loss for you.
Stop- Loss Limit Orders
This brokerage facility is the amalgamation of the aforementioned two tools. Stop-loss limit orders help investors set a floor and ceiling price for their investments, which, in simpler words, means that this feature of brokerage firms helps an investor to set a gain value with which they will be satisfied and loss value that they won’t cry over. Here is a short explanation on how this works-
Say, you bought a stock for Rs.500 with a target price of Rs.600, which forms the limit component of this feature and when it is reached, the stock gets automatically sold off. Since, there is always a risk of loss in investments and you, being a prudent investor, are well versed with the amount of loss, you will be fine with, let’s say Rs.450. This forms the stop-loss component of this feature. So, if the current market price of your purchased stock hits the lower bracket of Rs. 450, the stock gets automatically sold off.
Do you see how this arrangement is both a profit-booker & a loss-mitigator?
Price Alerts
Price alert is a facility offered by brokerage firms that lets a stock market participant receive the alerts in price movements and make the trade according to the data provided.
Since an investor/trader has already set a threshold value for his/her investment, this feature helps in notifying them as soon as the threshold is reached, after which the choice of making the trade lies in their hands, unlike the above-mentioned options.
The Bottom Line
“Far more money has been lost by investors trying to anticipate corrections, than lost in corrections themselves.” - Peter Lynch
Individuals must understand that all of their research-oriented bets in stock markets won’t be rewarding every time. But as a profit seeker, one must concentrate on minimising losses and not getting captivated in the stock market bubbles. But how do we do so?
This task is very much possible if one has an exit strategy in place, for the simple reason that it is the most important strategy for growth. It helps an investor/trader to exit at a bearable amount of loss, in addition to preventing them from entering any bubble-like situations in the market.
And as Robert Kiyosaki succinctly puts -
“Always start at the end before you begin.”
So, do you have your exit strategy planned beforehand? Tell us in the comments.
