(SMTS) Your Investment Portfolio: Crucial Investment Habits Every Investor Should Cultivate

October 16th, 2009

by Marc Lichtenfeld, Health Care Expert
Wednesday, October 14, 2009: Issue #1115

One of the marks of a good poker player is someone who can throw away a good hand if he thinks he’s been beaten. A less-experienced player might hang on to a premium hand, no matter what the board, or his opponent’s play may tell him.

Successful investors do the same thing. There’s an insightful trading expression: “Good traders know how to make money. Great traders know how to take a loss.”

The question is: Do you know when to hold ‘em and when to fold ‘em when it comes to your investment portfolio? When you buy a stock or option, you do so having undertaken your research and due diligence. It feels good to be doing something proactive that you expect to have positive results.

Nevertheless, it’s an act of faith – and when the investment doesn’t go your way, taking a loss is one of the hardest things to do following your initial optimism.

I’ve heard people say, “It’s not a loss until you sell.” That may technically be true, but I’ve also seen 10% losses on paper become 100% real-life losses with that mentality. And the truth is, when you sell for a loss, not only are you admitting that you were wrong, but you’re also taking a hit to your investment portfolio.

So with that said, I’m going to do something that is unheard of in this business…

Time to “Brag” About a Loser

Typically, investment analysts love to tell folks about all their investment portfolios and all of the wonderful gains they’ve racked up over the years. Of course, we’re truly happy with the winners and I’m personally very proud of my track record.

But I’m going to break with tradition and “brag” about a loser.

Thankfully, I don’t have too many examples of trades that didn’t work out, but I found one that perfectly illustrates several crucial investment habits that every good investor must cultivate.

In the August 2008 Xcelerated Profits Report issue, I recommended shares of a small medical device company called Somanetics (Nasdaq: SMTS). I did so on the expectation that earnings would increase as more hospitals used the company’s technology to monitor oxygen levels in premature-born babies.

But despite my best efforts, the trade didn’t work out. Here’s why…

The Right Way to Take a Stock Loss

If you remember, mid- to late-2008 was not a great time for the stock market. As a result, SMTS shares fell. In October, SMTS hit our customary 25% trailing stop at $16.46 and I instructed subscribers to sell their shares if they hadn’t put a stop in (which they should have).

But what if I’d been stubborn and let my pride get in the way of this losing stock?

Aside from being irresponsible to my subscribers, it would have been reckless, as shares went on to hit a low of $10.16 in March.

Yes, they’ve rallied with the broader stock market since then and have scrambled back to the mid $16s (where we sold it). But if I’d insisted that my analysis was right and that shares would eventually go up, subscribers would have had to live through the emotional turmoil of seeing the stock drop by more than 50%. On top of that, their money would have been dead for a year.

But by cutting our losses with SMTS, we were able to re-deploy cash into other winning investments, where we pocketed 11% and 21%. We also have a current open position that is up 20% and two that have gained 15% since entering them.

So while we took a loss on SMTS, it’s often better to just move on, rather than wait for the stock to meander back to breakeven, just because you refuse to sell for a loss.

Here’s a quick checklist…

Got An Exit Strategy? Here’s Your 4-Step Checklist…

Keep these four key rules in mind when you’re faced with a position that is in the red…

Use a Trailing Stop: I cannot stress this enough. Using stop-losses and/or trailing stops is something that all my colleagues here at Investment U advise. Simply put, it takes the emotions out of selling your position and resists the temptation for you to hang on in stubborn hope, rather than solid expectation. Selling for a loss is difficult, but if you have a stop-loss, the position is liquidated automatically. And if the stock creeps to your stop-loss point, don’t change your exit strategy. That’s a recipe for disaster. It’s there for a reason, so use it.

Don’t Let Trades Become Investments: If you have a reason for getting into a trade, such as a chart pattern or near-term catalyst, and events don’t unfold the way you expected them to, get out of the position. Don’t hang on to the stock if your original analysis has changed. Move on to the next idea.

Check Your Emotions at the Door: Sure, there are companies and people behind the stocks that you own, but you shouldn’t consider stocks any more than pieces of paper. Don’t assign any emotional value to a company just because it does something cool, or develops cancer drugs. You should buy and sell stocks with cold calculation, not because it gives you a warm, fuzzy feeling.

Use a Stop-Loss: See #1!

Believe me, I know what I’m talking about. Early in my investing life, I bought shares of a dot com company whose price eventually went to zero. I was raw and let my emotions drive my decision-making and never sold the stock. It makes me sick to my stomach when I recall how much I lost and how I could have avoided most of the pain if I’d employed a 25% stop-loss and exited the position. Even if I’d simply put the remaining money in the bank, at today’s low interest rates, I’d have paid for at least a year’s worth of my son’s college tuition.

Then again, maybe my eight-year-old son will be able to pay for college with his poker winnings. He’s becoming quite the player. Last time, for example, he folded pocket aces when he thought he was beaten. He was. But by saving his chips for a better hand, he then crushed his mom and me!

Hoping your longs go up and your shorts go down,

Marc Lichtenfeld

View original at: Investment U