An Important Rule of Lasting Wealth

One of the most important rules of profitable investing (and profitable business too) is to get out of losing ventures quickly and spend more time and money pursuing your best opportunities. If you can follow the straightforward technique I’ll outline for you here, you’ll never lose another night’s sleep worrying about which way your investments will go the next day.

Because, unlike most investors, you’ll have a plan — knowing when to get out and when to stay in for the biggest possible profits. To give you an idea of what I mean, let me give you a simple example. Imagine that you own two shirt businesses. One sells T-shirts on the beach. The other sells golf shirts at pro shops around your hometown. The golf-shirt buyers are much more discriminating, and, although the selling price is higher than what you charge for the T-shirts, your profit margins are much lower.

After a year in business, you notice that your T-shirt business is making an annual return in excess of 50% while you’re losing money on your golf-shirt business. Lots of people would make the mistake of trying to fix the golf-shirt business. They don’t understand one of the Key Laws of Lasting Wealth: Cut your losses and let your winners run. MMF has made this point many times with respect to businesses. But this principle is just as important in the stock market.

If you own two stocks and one goes up 50% while the other goes down 25%, most people will sell the stock that’s up and hang on to the one that’s down — or even add to the down position because “it’s cheap.” Big mistake. Always cut your losses in the stock market. The phrase to remember is: “Let your winners run and cut your losers short.” Buying investments, you see, is only the first half of the equation when it comes to making money.

Most people don’t understand the hardest part — knowing when to sell. In order to invest successfully, you need to put as much thought into planning your exit strategy as you put into the research that motivates you to buy. The exit strategy I advocate is simple. I ride my stocks as high as I can. But if they head for a crash, I have my exit strategy in place to protect me from damage. Though I have many levels of defense and many reasons I could sell, if my reasons don’t appear before the crash, the Trailing Stop Strategy is my last-ditch measure to save my hard-earned dollars. And it works.

The main element to the Trailing Stop Strategy is a 25% rule — no matter what. I sell any and all positions at 25% off their highs. If, for example, I buy a stock at $50 and it starts dropping, when would I sell? When it hit $37.50, or 25% off the high. If it starts at $50 and rises to $100, and then starts dropping, when would I sell? At $75 … again 25% off the high? Make sense? What’s so magical about the 25% number? Nothing in particular — it’s the discipline that matters.

The point is that you never want to be in a position where a stock has fallen by 50% or more. This means that a stock has to rise by 100% or more just to get you back to where it was when you bought it. By using this Trailing Stop Strategy, chances are you’ll never be in that position again. I use end-of-day prices for all my calculations, not intra-day prices. You should too. This makes things easier. If a stock has gone to $100, put at least a mental stop at $75.

If, subsequently, the stock closes at or below that $75 level, sell your shares the next day. I have to admit that it took me three years to truly follow my own advice on this one. I would always come up with some excuse for why I should keep holding some dud stocks. Nearly every time with those losers, I’d have been better off if I’d cut my losses at 25%. Now I always use my trailing stop. And once you get into the habit, and commit to doing it, it’s easy.

The trailing stop dictates two common-sense fundamentals: (1) Taking small losses is much better than taking big losses and (2) letting your profits run is much better than cutting them off prematurely. If you follow this simple plan, your investment results will start to improve immediately and dramatically.