| Separating the Good From the Bad As a successful software developer and serial entrepreneur, I'm all about "best practices" in my business efforts. And I bring that same "best practices" mindset to my personal investing efforts - and to the investing products and strategies we develop at TradeSmith. You've heard me talk about those best practices - by focusing on dividends, "forever stocks," cash flow, economic "moats," buying businesses and not stocks... And risk management - which includes selling your losers. The fact is that investing is really an exercise in probabilities and risk management. Even the best ideas can, and do, fail. So how do we know which stocks to cut - and when to cut them? Start by keeping it simple. Have a game plan before you make an investment. Before I buy any stock or take any options position, I make sure to determine three things... - The reason behind the investment
- The points along the way where I'll reexamine the trade, justify it anew and assure myself it continues to make sense
- The maximum "pain point" (quantified by a stop loss) where I'll sell the stock or close out the options trade - no matter what.
If the reason gets "broken," if I can no longer justify the holding or if that "pain point" is reached, I take the "cold plunge" and cut the investment loose. For traders, this is all pretty straightforward. You find a setup or probable pattern; select your entry, stop loss and profit target; and place the trade. It's a little more difficult for investors. Take the recent collapse in technology growth stocks. Investors believed that many of these companies - ventures like Carvana Co. (NYSE: CVNA) and Twilio Inc. (NYSE: TWLO) - had long runways to spool up their businesses. Investors believed there would be big profits far in the future - which persuaded them to imbue those companies with hefty market valuations. But that kind of valuation model makes sense only in a period of low interest rates and a predictably healthy economy. With inflation raging, the U.S. Federal Reserve changed that calculus. Take a look at the weekly chart below for Carvana. If you had followed our TradeSmith Finance signals, you would have entered a position just shy of $100 in May 2020. The stock peaked just above $360 before it rolled over and hit its $184 stop loss in early January of this year, at which point you would have sold your shares. This is a great example of a "cold plunge" that would've kept you healthy: Today the stock trades at around $7. What's especially interesting is that the stop loss was triggered around the same time that I would have said the Fed's expected actions changed the landscape. That's a big reason I rely heavily on our tools. They make decision making easier by removing emotion and instilling a discipline that's easy to see, explain and adhere to. No One Likes to Lose Dumping stocks for a loss isn't fun. In fact, it downright stinks. Yet it's a rite of passage for every trader and investor. As I mentioned earlier, stocks and options are exercises in probability. That means we sometimes have to take losses. We know that intuitively. So why is it so tough for us to take a loss? I was talking with a friend of mine who's a trader. For years, he struggled to accept his losses - because he didn't consistently win. Without the conviction that his wins would outweigh the losses, he feared taking a loss. Ironically, that made his problems worse. No one can successfully navigate the market over time without employing proper risk management. A big part of that is limiting our losses. Remember, if you take a 50% loss on a stock, the share price has to double just to get you back to even. Only then can you get back to actually making money. And the probability of that happening is pretty low. That's why it's best to take that "cold plunge" - and endure the near-term pain of dumping the stock - before you get to a 50% loss. What most of us don't realize is that a dollar won or a dollar lost is still a dollar. In other words, every dollar you save yourself is worth the exact same amount as every dollar you win. Winning and losing are just different sides of the same coin. Once you realize and accept this simple truth, it becomes much easier to understand why it's just as important to manage a losing position as a winning one. Follow the Plan Naturally, that leads to this question: How does someone learn to cut their losses? As I said at the outset, successful investing starts before you buy a stock or an option. An easy way to create this kind of discipline is to keep a journal. With each stock or option trade you consider, write down those three things I mentioned earlier: your reason for entering the position, the points at which you'll reevaluate it, and the point at which you'll take that "cold plunge" and close it out. And be sure to follow through with a review process. Take 15 minutes or half an hour every week to scroll through your positions and check that none of the criteria has been violated. Personally, I use the stop losses from TradeSmith Finance to make sure I stay on track. This not only automates the regular review but also removes the emotion and gives me algorithms that signal when it's time to sell. Look, I get that not everyone is comfortable turning their future over to a computer. Just like not everyone is comfortable with a "cold plunge." But both lead to robust health. I can say that with sincere confidence about TradeSmith's tools, thanks to the development work, market analysis and rigorous backtesting that have gone into our systems. However you choose to go about it, make sure that you do so with clear, objective criteria that can tell you unambiguously whether to keep or drop a position. And when you do come face-to-face with a loser, take the "cold plunge" and cut it loose. It'll sting in the near term, but it'll leave you feeling healthy in the long run. And it's in the long run where the real wins - the real wealth - are created. Have a nice day, Keith P.S. Interested in learning more about TradeSmith's tools? Tomorrow, December 14, I'll be sitting down with Alexander Green and Chief Income Strategist Marc Lichtenfeld to discuss how to use TradeSmith's proprietary tools to add $50,000 or more to your income over the coming year - without buying any new stocks, bonds or options. We're calling it The 2023 $50,000 Income Challenge. It's completely free to attend. Simply click here and enter your email address to reserve your spot for the online event. | 
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