How to Invest in Stocks | Trading System Part 2

There are 2 reasons why you sell stocks that you invested in: Selling to cut your losses or Selling for profit.

The first is often ignored by beginners. They only worry about what stocks to invest in, probably with the intention of keeping it for life (the typical Buy-and-Hold investors). Buying and holding stocks has major advantages.

1. Firstly, minimal work is needed; just do your research, invest in the right stocks and never worry about selling it.
2. Secondly, if you invested in the right stocks, such a strategy can normally produce higher yields compared to repeated buying and selling (especially after taking commissions into consideration).

BUT, and that's a big but, if you invested in the wrong stocks, buying and holding can easier blow your account. Consider the dot com bubble in 2000, if you had invested in JDSU at its highest price ($1227) back then, you would have waited for eight years to find that its stock price is worth only $13.94 on 1 Apr 2008, never returning to its peak or even getting close to it. Or consider the more recent example of JSDA, worth $32.60 at its peak, lost more than 90% of its value in less than a year. Therefore, unless you believe you'll be able to live up to a hundred years old and can patiently wait for the stock you invested in to rebound to its previous value, ignoring to cut loss is one of the easiest way to blow your account.

Although there's no fixed rule for deciding when to cut your losses, I recommend never holding a stock beyond a 10% fall. That it, if you invested in your stock at $40, the biggest loss you should tolerate is $4 (10% of $40).

The next reason for selling your stock is when you've made a profit. Again, there's no formula for selling at a profit. It depends on your appetite for risk, your trading timeframe and most importantly, your personality. Some techincal analysts recommend a 3-to-1 profit-risk ratio. That is, for every $1 you risk, you should demand at least a $3 profit. So if you invested in the stock at $40 and will cut your loss at $36, you should demand a profit of at least $12. Other experts prefer to use a trailing stop, selling at a certain percentage of the maximum profit you gained after you invested in it. For instance, if you used a trailing stop of 10% of your profit, and the highest gain you achieved is $1000, you'll sell once the profit drops to $900 (after your maximum gain dropped by 10%).

Regardless of whatever rules you prefer, you must make sure your trading system has such rules for clearly deciding when to sell. These rules are probably more important than rules for investing. Even if you are the best stock picker in the world, you will definitely have one or two bad picks (and yes, Warren Buffett sells his stocks too. Even though he is famously known for saying the best time to sell a stock is NEVER, he DOES sell his stocks). Your occasional bad stock picks are the ones that can break your account.