The Indispensable 'Exit Plan'

‘Redundancy’ is a common term and vital practice in mountaineering. It involves having systems of backup to save the climber’s life when things go wrong, and things frequently go wrong deep in the snow-covered mountains. Ice climbers often use several ice screws to maintain a position in case one or two fail. Glacier travel involves roping every important utensil to the climber’s harness, and every climber to other climbers in case of a crevasse fall, and on steep terrain, every climber to a fixed line on the mountain in case of a ‘slip and fall’; that’s a lot of ropes! Redundancies act as safety nets to maximize the probability of physical survival.

The stock market is contrarian in nature, well equipped to inflict the maximum amount of pain on the largest number of investors possible, and responsible for claiming the financial lives of millions of investors throughout human history. Warren Buffet, Charlie Munger, and many notable investors have suggested the avoidance of a catastrophic loss is the single most important aspect of investing, yet few individual investors maintain a formal exit strategy to mitigate loss exposure on risky assets! Wall Street touts a buy and hold strategy, probably motivated by an interest in protecting their fee structure, but has no answer for the thousands of American investors who went broke during the several market crashes in the last century alone that took decades to recover.

It's no more advisable to own an adored risky asset without a formal, preconceived ‘Stop-Loss’ order than to solo traverse a soggy glacier on a sunny day! The S&P 500 is close to the highest valuation in history, probably making this a wise time to understand and maintain the very important ‘Stop-Loss”. Here are some basics to familiarize us with the practice:

  • A ‘Stop-Loss’ order involves a pre-selected price, below the present market price, at which shares of a stock will be sold to limit a potential loss. It’s notable these orders should not be entered into the trading system due to the potential for price abuse but should be tracked personally. It is frequently advised that positions with a triggered ‘Stop-Loss’ should be sold the following business day at the market.

  • A ‘Hard Stop’ involves selecting a price at which the security will be liquidated, and the sell price never changes. This strategy is often coupled with that of compounding dividends of high-quality businesses over decades.

  • A ‘Trailing Stop’ involves selecting a sell price that is a certain percentage under the price paid, and in the case the price initially rises, immediately becomes the recent high price. This strategy allows the investor to ride the bull market in a stock or index to its ultimate peak without seeing the risk of loss increase. 

  • TradeSmith’s ‘VQ Trailing Stop-Loss’ program adds a specific volatility quotient to the ‘Trailing Stop-Loss’ order for publicly traded securities. This strategy tends to keep holders invested in a stock longer than the simple ‘Trailing Stop-Loss’, and according to the company, more profitably; both back-testing and their subscriber list suggest TradeSmith is correct on the matter.  

The critical function of the ‘Exit Plan’ is to manage risk by putting formal protections in place, an important factor since high inflation is forcing all investors to take more risk than they otherwise would. It also provides confidence and peace of mind for investors in knowing their sell decisions are thought-out ahead of time, reducing the likelihood that an emotional decision will be made in a large market drawdown, which is a recipe for heavy losses.

Think about it, and may God bless our wealth protection efforts.

Shaun.

“Rule #1 is Don’t Lose Money. Rule #2 is Don’t Forget Rule #1” ~Warren Buffet

“The prudent sees danger and hides himself, but the simple go on and suffer for it”. ~Proverbs 27:12

The opinions voiced in this material are general and are not intended to provide specific recommendations. Stop-Loss orders do not guarantee against loss of principle. When entered into the trading system Stop-Loss orders become market orders when triggered, and can then be executed at a price lower than the price initially entered; in such circumstances the Stop-Loss order can also expose investors to algorithmic price abuse.

 

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