Reduce risk Adopt an exit strategy

August 17, 2011
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, NAIROBI, Kenya, Jan 21 – With the increased interest that Kenyans are taking in the financial markets and especially now that we have been in a prolonged bear run and facing a possible market bottom, it is important to consider important investment concerns like;

–    What is the right time to make entry into stocks?
–    How can you tell if the market will be bullish or bearish? If you enter the market and prices plummet, should  you sell and cut your losses or hold on and ride out the storm?
–    What if any are the opportunity costs of such a strategy?
–    And are there any chances of recovery? On the other hand some investors may be in possession of stocks they bought at the apex of the Bull Run and have therefore depleted in value during the bearish period from mid 2008.

Your Risk profile
It is advisable for investors to decide whether they are bullish or bearish. Research has shown that fence sitters never make money. Bullish investors buy shares hoping the prices will rise, while bearish investors sell their shares when the bulls are buying anticipating an imminent bear run.

The pigs, on the other hand, hold on to stocks even after they have made substantial gains hoping the prices will increase even further only for the price to correct itself and they lose out. Whereas bullish and bearish strategies have the potential to make profits, pigs that have greedy strategies never make reasonable gains. The exception being those long term investors only interested in dividends and long term capital gains.

Common Investor choices
Few investors have any contingency strategy for the eventuality of tumbling share prices and consequently they end up hanging onto shares in the hope that their fortunes will turn around and return a profit.

This stratagem may not be the ideal course of action. For one, the share price may continue to decline and there is no assurance of capital preservation. For this reason the investor may forego other profitable opportunities since during the period the investor is holding onto losing shares there are alternative investments that have potential for gains and their money is held up causing them opportunity costs.

In such circumstances, investors should consider selling plummeting securities marginal losses and channel the proceeds to more promising shares targeting gains to offset the losses incurred and ultimately realise a profitable return.

With this in mind an investor should have a well planned exit strategy to go with their entry strategy.
It is futile to hold onto shares that are in the profit and begin scrambling to sell when the share price starts to decline – chances are that no one will be interested and the investor will end up losing opportunities elsewhere in the market.

Exit Strategy
An exit strategy is of value for investors in such situations, here are some tactics that are simple and easy to put into practice.

A stop loss order is one that puts a sell order on the investor’s shares once they have reached a predetermined amount of loss that the investor is ready to risk after entering a long position on a 
Share.

Since shares move in both directions in a volatile market, the investor can start by setting the stop order at say two percent below the original entry point to minimise any losses that may occur at entry. The idea here is to closely monitor the stock price and when it rises beyond the entry position the shareholder can amend their stop point to the entry level price covering any possible loss that can occur from that point on ‘transaction costs should be taken into consideration here’. Note that the investor can leave the share tracking to their stock broker who will execute the order at no extra cost when the condition is met.

From this point on, the investor has two options, either to keep raising the stop order to trail the rise of the share price, or to leave the stop order just above entry point and wait it out until they decide to exit. The option to trail the share can be a disadvantage since a small downturn could trigger the sale and then a consequent upturn would mean the investor loses on an opportunity to realise higher gains.

This gives rise to the importance of the investor tracking the general trend of the share price. On a positive note, the strategy allows the investor to exit at the peak of the increase in price and maximise the returns. The fixed stop may protect against loss but the decision to exit remains with the investor and they must watch for downturns themselves. Setting a target at which to exit e.g. 20 percent increase in price and sticking to it is a good idea – remember what happens to pigs!

A time based exit strategy is also a good option for investors, in this method the investor sets a time period in which they expect to hold onto a share. The investor in such a strategy can also set a target return at which they will be happy to exit even before the set time window expires, investors should be prepared to exit with less rewards if the time period expires before they have hit the target price. Time based exit strategies help the investor take advantage of the best price within a set timeframe especially when investing in cyclical stocks.

Ultimately, the investor has to break even and a price based strategy is best put in place before one can consider a time based exit strategy. Once the breakeven point has been secured the investor may choose to switch to a time based strategy by setting a target reward price they expect and setting a time frame within which to exit their position.

A cautionary point is in order here! For the speculative investor who may exit due to a temporary reversal in the share’s direction to avoid losing the profits they have already made, watch out since the reversal could be temporary and fear can cause you to make a hasty exit often followed by a hasty return into the market to cash in on the rising share as a result of greed, such moves will pile up transaction costs and can eventually eat up all your profits thus transferring all benefit to the NSE, regulatory bodies and your stock broker. Speculators should pay more attention to the trend of the share price over a reasonable period of time instead of concentrating on daily price movements to avoid such situations.

Trend analysis which is carried out by most stock brokers and investment banks is of great use to investors who want to take the positions discussed in the stock exchange. A rule of thumb is to buy low and sell high and to remember that the trend is your friend so invest in it. This is manifest in that no one can actually predict the behavior of a share price. Long term investors are normally immune to most of the volatility issues since they tend to grow with the market, take dividends and weather out the fluctuations caused by fundamental factors and market sentiments. 

For those investors who speculate we owe the volatile nature of the markets to you so keep on trading but be cautious!
 
No investor is exempt from the effects of market volatility and research has shown that the market is in itself unpredictable. It is no wonder that some people make large benefits through formulation of good plans to mitigate the risks that arise due to the volatile nature of the stock exchange.

More interest in every day market movements and access to more information about the companies that one invests in are some ways that help investors to make informed decisions. Blind speculation is gambling and active investors are better off using the information and services offered by their brokers and investment managers to make informed decisions. Company financial statements are also an ideal source of information and should not be put away to gather dust!

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