Your goal is to always have an exit strategy before you enter an investment, meaning knowing when to cut your losses. And one of the simplest (but rather crude and arguably too simplistic) idea based upon the assumption that you have a 50% chance of being right given that you "guess" the winning stock is the 2:1 rule.
For example, if you have done your research about a particular company, let's say for example you are following DBS's stock, and the current price today is $26.97 at close.
Let's say after careful research, you are quite sure that you have a good target share price of 28 dollars for DBS for this year. This puts the stock at a 1 dollar undervaluation, and your profit per stock being $1 if you plan to take profit exactly at the intrinsic valuation of $28. Now, assuming you are right, then that $1 is yours for the taking. But no one possess perfect future sight, so that $1 of profit is not certain. DBS's stock may instead tank, making you incur losses instead. Without a predetermined exit level, you will never know when exactly to cut your losses, and instead may hold onto a losing stock for longer than necessary, resulting in more losses.
So, a simple trick is to always place a stop loss order on your investments in a ratio of 2 (profits): 1 (loss). If you expect a $1 profit, you are willing to take a $0.50 loss. So for this DBS case, you place a stop loss at $26.47. Once DBS drops to this level, the system automatically sells off your stocks for you to cut your losses per stock at 50 cents. Some people may be less comfortable with the risk, and go with a 3:1, some more comfortable, and go a 1:1. But the general idea is to place an absolute rule that you will bow out of the investment once level is hit.
Of course, this is an extremely crude way of looking at things. There are a few factors you have to consider - the volatility of the stock price, which may cause you leave the investment pre-maturely due to incorrect profit and loss assumptions that are too narrow, the timing of your investment, when you enter the investment at the wrong point of the business cycle, and so many other factors. But this rule is purely based upon the assumption that the market is a casino, and you are betting against the house with a 50% chance of winning. a 2:1 ratio would give you a good chance of making modest profits.
However, as we know, it is never good to bet against the house. The market should never be thought as a casino. Investing is never a game of gambling, but of prudent research and analysis. However, the general idea is still the same, without an exit strategy, you will never leave, it is within our nature to always hope for the best! So why leave yourself up to fate and whim of your emotion, when you can make calculated decisions based on facts and logic?
Your goal is to always have an exit strategy before you enter an investment, meaning knowing when to cut your losses. And one of the simplest (but rather crude and arguably too simplistic) idea based upon the assumption that you have a 50% chance of being right given that you "guess" the winning stock is the 2:1 rule.
For example, if you have done your research about a particular company, let's say for example you are following DBS's stock, and the current price today is $26.97 at close.
Let's say after careful research, you are quite sure that you have a good target share price of 28 dollars for DBS for this year. This puts the stock at a 1 dollar undervaluation, and your profit per stock being $1 if you plan to take profit exactly at the intrinsic valuation of $28. Now, assuming you are right, then that $1 is yours for the taking. But no one possess perfect future sight, so that $1 of profit is not certain. DBS's stock may instead tank, making you incur losses instead. Without a predetermined exit level, you will never know when exactly to cut your losses, and instead may hold onto a losing stock for longer than necessary, resulting in more losses.
So, a simple trick is to always place a stop loss order on your investments in a ratio of 2 (profits): 1 (loss). If you expect a $1 profit, you are willing to take a $0.50 loss. So for this DBS case, you place a stop loss at $26.47. Once DBS drops to this level, the system automatically sells off your stocks for you to cut your losses per stock at 50 cents. Some people may be less comfortable with the risk, and go with a 3:1, some more comfortable, and go a 1:1. But the general idea is to place an absolute rule that you will bow out of the investment once level is hit.
Of course, this is an extremely crude way of looking at things. There are a few factors you have to consider - the volatility of the stock price, which may cause you leave the investment pre-maturely due to incorrect profit and loss assumptions that are too narrow, the timing of your investment, when you enter the investment at the wrong point of the business cycle, and so many other factors. But this rule is purely based upon the assumption that the market is a casino, and you are betting against the house with a 50% chance of winning. a 2:1 ratio would give you a good chance of making modest profits.
However, as we know, it is never good to bet against the house. The market should never be thought as a casino. Investing is never a game of gambling, but of prudent research and analysis. However, the general idea is still the same, without an exit strategy, you will never leave, it is within our nature to always hope for the best! So why leave yourself up to fate and whim of your emotion, when you can make calculated decisions based on facts and logic?