Ask Colin

The prices of some of my stock have moved well above my stop. What should I do?

The detailed question was:

I have built two investment positions to around 6% of my capital. Because their prices have increased, both investments now exceed 6% of my capital. What troubles me is that the distance back to my sell stop is now greater than 1% of my portfolio. The prices have not, however, doubled so I have not reached the position of selling 50% using your investment plan. How would you resolve this dilemma?

This is a problem I like to have. Your sell stop is protecting profits rather than cutting losses, which is a far worse problem.

At one level, your discomfort is part of the nature of investing. In order to make good profits on investments you need to assume some risk. If everybody knew what was going to happen, there would be no profit to be made because everyone would want to buy those stocks and few holders would want to sell to them. The price bid and offered would quickly move to a level that left little opportunity for further price increases.

As explained in my book Builing Wealth in the Stock Market and illustrated in the case studies in particular, the initial sell stop is to cut losses and is limited to no more than 1% of capital in my plan. In fact it is often lower than this – 0.5% is not unusual for me and is now closer to my norm. So, when the investment doubles in price, the risk back to my sell stop may be less than 1% sometimes and greater at other times. It will sometimes be a sell stop which cuts a loss, but later is more likely to be a sell stop that protects a profit. In both cases, it is important to develop the mindset that you have to risk some of your paper profit or your investment capital to let your profits build. It is not easy, because behavioural finance research has shown that we humans tolerate loss far more readily than we tolerate risk to our profits. We tend to have an impulse to snatch profits quickly and to let losses run, hoping things will come good if we hold on. This natural impulse is the exact opposite to what a successful investor must do. It should be branded into our forehead that we should try to let profits run, but cut losses quickly.

I hope this explains your discomfort and that you realise that it is both natural and also something you need to deal with.

I can offer some ideas that may help you to manage your situation.

The first idea, and I think the best approach, is what I do. I always situate my sell stop where the logic of my investment plan says that it should be. I continue like that until I get a sell signal. My sell stop is moved up under the last significant trough in the trend every time a new high is made above the last significant peak in the trend. However, as explained in The Aggressive Investor, this is only one of three sell signals I use. What tends to happen quite often in these situations is that I get one of the other two sell signals occur at higher prices than my sell stop. I then sell on that signal. This is the approach that I would commend to you if you are able to follow it. I am the first to acknowledge that it is not easy and that it may take you some years of experience to start to trust that it will work.

The second idea is that you mentioned that the prices of your two investments had risen sharply, but had not yet doubled in price. At that point, you indicate that you would follow my investment plan of selling half your holdings. This is my approach, but it is not carved quite so much in stone as you seem to imply in your question. The key for me is that a doubling in price is a guideline. 100% is not a rule set in concrete. What I did not perhaps explain well enough in The Aggressive Investor is that it is a guideline, not a rule. What I do in practice is to use it as a guideline level, but I still use some judgement in applying it. If the price rises sharply to, say, 185% of my purchase price and then comes off a sharp peak, I would most likely sell half the position at that point. In like vein, if it gets to 200% of my purchase price and is still moving up strongly, I would not sell automatically on it having doubled in price. What I would most likely do is to allow it to keep rising strongly until it comes off a strong peak and act at that point to sell half of my position.

I hope this clarifies something important for you, but of course it may not resolve your discomfort. If your two shares keep rising strongly, your discomfort may in fact increase.

That brings me to the third idea, which may help you while you are still learning the craft, but which I feel is my least preferred resolution. There is an old saying on Wall Street, which I have repeated many times over the years, that if your position is so large that it causes you to lose sleep, you should sell it down to the sleeping point. Let’s assume from your question, that at the present stage of your journey to investment skill, you are uncomfortable with a risk back to your sell stop being greater that 1% of your capital. What you can do is to sell as much of your position as brings the risk on the investment back inside 1% of capital. If it keeps rising inexorably, you may have to do this more than once on some rare occasions.

This approach to your discomfort is not ideal, as I have explained, but is far better than selling all of your holding and not having any of it continuing to build if the price just increases for some time.

The one thing that you might consider, but which I think is very incorrect, is to break the rules of your investment plan by moving your sell stop up closer than the logic of your plan says it should be. This is often called tightening your stop. It makes no logical sense within your investment plan, if you have a tested level that works on the probabilities, to move the stop closer, where a price movement that is normal for your plan would hit the stop. You would then likely sell the whole holding and maybe miss a long sustained move to the higher prices that your original plan envisaged with the normal sell stop.