Even in the middle of a bull market, which by most estimates is the longest expansion in our nation’s history, stocks have corrected sharply. In fact, recently, one market strategist, Andrew Lapthorne, of SG Securities, warns that despite their outward appearances, many stocks are struggling. In some cases, they are well of their levels of 18 months ago. If you’re listening that means that many institutional investors may be getting ready to take profits. Are you?
A misunderstood, yet highly effective strategy of successful investors is taking profits. Just as knowing when to buy a stock, it’s important to know when to sell. But the act of exiting a position while a stock is still climbing seems counterintuitive. What if the stock keeps rising? How much is too much? How much is too little? To help answer those questions, it’s important to understand what profit taking is all about.
Profit taking is not trading on the news
In 2019, investors have been buying and selling based on news surrounding the U.S. and Chinese trade war, the jobs report, the Federal Reserve and their position on the future direction of interest rates. This kind of trading has created volatility in the market as traders actively enter and exit positions. The problem with trading on the news is that the trading can be emotional … and frequently wrong.
Thou shalt not lose money
In the end, that’s what profit taking is all about, not losing money. Successful investors hate to lose money more than they love making it. Investors who have a regular profit taking strategy understand that markets don’t rise forever. Profit taking is systematic and unemotional. The goal of profit taking is the preservation of capital. It is an exercise in risk avoidance.
Profit takers don’t work harder – or smarter
Two common investing myths are that successful investors are more active traders and are plugged into the market 24/7. Another myth is that the most successful investors just have access to better information. This might be framed with investors suggesting the market is “rigged” against them. There is no evidence that suggests active traders are any more successful than other investors. And while some investors may have access to some information, the most relevant information is available for investors through public resources.
The simple truth is that successful investors don’t work harder or smarter. They make a plan and they stick to it. Part of any successful investment plan is the ability to know when to take profits. In this way, they take profits – even when an asset is continuing to rise in price.
What Mark Twain can teach us about market momentum?
Mark Twain is given credit for saying “History doesn’t repeat itself, but it frequently rhymes”. The same can be said for markets. One of the problems for individual investors is that profit taking goes against their natural reaction to ride the wave. The flaw in that strategy is that markets react to momentum and momentum is not always rational. While it is virtually impossible to time the market, the market is somewhat predictable. Part of the reason for that predictability is institutional investors set price targets for profit taking. When a stock reaches those targets, they sell. Period. No exceptions. There’s no emotion to their decision. They just take the profits and keep their portfolio in balance.
Profit taking is not just for traders
You might be thinking, “But I’m a long-term investor with a pretty high-risk tolerance. I practice dollar cost averaging; I’m just buying stocks on sale.” Yes, many successful investors “buy on the dips”. But profit-taking does not mean closing a position entirely. It’s about balancing your portfolio. There has been many a small business that has relied too heavily on one or two clients. The risk is if they lose that client, they have no way of making up the lost revenue. It’s the same for a portfolio. Taking some profits from winners and putting it into your weaker performers or just parking it as cash is a smart way to keep your portfolio in balance.
Understanding profit taking strategies
If I haven’t dropped enough clichés on you, here’s another one. When it comes to profit taking, failing to plan is planning to fail. Having a plan is essential. But every investor is different. For example, there is some conventional wisdom that says an investor should remain in a trade until it has increased by 20-25%. The thinking is that 25 percent is a common point of resistance and the stock is due for a correction. But some professionals will say 20 percent is too high and advise profit taking when a stock rises by 15%. It really doesn’t matter which number you use. You may find that you have different price targets depending on the stock. That’s okay. The point is to find a point of significance and stick to it.
Another strategy is to follow the lead of the big boys. Many financial sites, like MarketBeat, provide information about the trading activity with institutional investors. There are many reasons why company insiders might sell their stock, but when you see large investment banks selling a stock it’s reasonable to ask yourself why they are doing that?