It’s easy to get carried away when investing in a hot stock. Here’s how investment manager Chris Robertson decides when to buy and when to sell:

 

Cut your losses and let your winners run

If you have a loss the natural tendency is to want to hang onto it in the hope the loss reverses and you make your money back. Whereas if you are making a profit you want to take the profit and run because it’s a good feeling to have a winner.

You should flip this tendency. Cut your losses early and continue holding the winners – remember the easiest way to have a big loss is to start with a small one.

 

Let the next trader take the risk

If a stock has rallied hard over a short period of time, say 50 to 100 per cent, the probability of the rally continuing reduces and the probability of a pull-back increases.

It’s better to review the investment, look to take profits and let the next trader take the risk of a pullback.  I often see traders hang on for that last 10 per cent only to see the stock price retrace to where it started.

Hand off the risk to the next trader and recycle your capital into something else. If you have made a profit that seems too good to be true, it likely is and you can see stocks go back down very quickly.

Typically it’s a big return in a short period of time, if you look at Bubs Australia (ASX:BUB) it rallied 35 per cent on the IPO, then pulled back and then rallied to 93c over a short time period.

Since the IPO at 10c per share early in the year it was up more than nine times. With a rapid run like that the likelihood of it continuing has diminished. You should put your profits in your back pocket and leave the risk to someone else.  Bubs is currently at 50c.

 

Chasing is a one-way ticket to the poor house

When a stock rallies, investors often experience FOMO and pile in. Typically, by that stage the information is already priced in, the run is slowing and the savvy traders — the early ones in — are in fact exiting.

Herding perpetuates stock price momentum and leads to long-term overshooting of share prices on both the upside and downside.

Financial markets are based on everyone’s individual assessments of the same available information and it is easy to get sucked in to the information vacuum. Forums can be unhelpful because people are posting anonymously and you never know what they are trying to peddle.

The best way to control that is to know your entry target and stick to it. You need to be disciplined on your entries because if something has rallied and you try to get in above your target entry price, it’s often time to get out.

 

Buy the rumour and sell the fact

Whenever there is an impending announcement, say a new product launch or drill results, often everyone wants to buy in on the hope that it’s going to be good. They don’t want to miss out.

Once it is announced, it often doesn’t live up to what people expect and the price can often revert. You often see this with product launches, biotech approvals or drilling announcements.

Future uncertainty that causes traders to irrationally cling on to some fact or information that should not affect decision making is called an “anchoring bias”. Often this causes rallies into news events, then once the news is known traders sell and the information uncertainty has gone.

A good example of this is Thred (ASX:THD). In the lead up to the app launch in mid-May the share price rallied but after it launched the price weakened.

 

Recent performance may not be the best guide

People have a natural tendency to rely more on recent observations than past events. They extrapolate this information too far into the future when, in fact, more reliable longer-term averages are appropriate.

In sport, this is known as the ‘hot hand fallacy’. A player is often selected for a crucial task on the basis of a good recent performance, rather than a player with good long-run statistics.

This is true in investing as well. People sometimes mistakenly believe that if a stock has gone up ten days running, it is hot and will continue to rise.

 

Chris Robertson is a Sydney-based Investment Manager who has been working in the investment management industry globally for more than 25 years. He is director of Arthur Austin Advisory.

In his monthly column Chris brings insights to Stockhead honed by years at the investment coal face. He is on Twitter @ChrisRobbo01.

 

This article does not constitute financial product advice. You should consider obtaining independent advice before making any financial decisions.