If You Want to Make Money, You Need an Exit Strategy. Here's Why...
This week we got up to speed with Fergus' thoughts on exit strategies, one of the most effective ways for any trader to mitigate risk.
"Everyone thinks they can do it, but when it comes to it, most people get caught up in the game"
Monkey Trap: The Price of Greed
The monkey trap is Fergus Cullen's favourite analogy for the importance of an exit plan:
The trap itself is very simple, it’s a coconut with a hole the size of a monkey’s hand, the coconut is then filled with nuts and tied to a tree. Now a monkey can easily get its hand in, to grab the nuts, but once it’s holding them its fist is too big to get out of the trap. A smart monkey would realise that if it let go of some of the nuts it could squeeze its hand out, but monkeys are too greedy to let go, they hold and hold until the hunter comes back.
“If you try and hold on to every cent of a bull market, you will get killed”
This is the basis of Cullen’s exiting strategy, you need to accept leaving with fewer nuts. While it may feel good to hold onto everything, to try to catch the top of the market, if you “have the conviction to ride some of these stocks to nosebleed levels, by default you’ve set yourself up to ride it down the other side”.
Cullen emphasises the lack of liquidity at the top of a market as the volume of marginal buyers falls and as smart investors realise that the rise is over and cash out. At some point, there will be a lot more sellers than buyers, which makes holding onto your position so dangerous.
Why You Need an Exit Plan
Cullen believes that creating an exit strategy long before the euphoria of an upsurge is the key to successful trading. His primary focus is ‘scaling out’, slowly withdrawing from a position by incrementally selling shares, perhaps 10% at a time. Having an exit plan, particularly one that involves scaling out has a lot of upsides:
The emotional extremes associated with the rise and fall of markets are dangerous to any trader, getting caught up in excitement is an easy way to trap yourself in a trade you should have exited long ago. A plan helps you to focus on the fundamentals and lets you access logic in a time when the emotion has taken over.
One of the hardest things about exiting a trade early is that other people will continue to make money once you’ve left; this was well summed up by J.P. Morgan who said
“there is nothing in this world, which will so violently distort a man’s judgement than the sight of his neighbour getting rich”.
By scaling out you can continue to take part in the market whilst negating as much risk as possible.
Marriage to Popular Companies
Tying yourself to a company is a sure-fire way to lose. In the era of Bitcoin and Tesla, far more traders, particularly those without much experience, are marrying themselves to popular companies. This type of investor can completely lose track of the purpose of investing, to make money.
Cullen argues that this is akin to joining a cult, ignoring the available information and refusing to make rational decisions. Having a pre-determined plan will give you the clarity you need to focus on the fundamentals and exit a position at the right time. Take the emotion out of your investing.
Scaling out is one of the best protections against the distress of hindsight bias. You never know exactly when a market will peak, but by slowly withdrawing you can make the experience less painful, you can continue to benefit from growth without risking your entire position.
Cullen also believes this method is an effective way to remove the temptation of buying back in “even if you ride it right to the top, and possibly down the other side, with your last 10%, you’ve partaken in the bull market and you’ve protected yourself from yourself”.
To put together an exit plan you need an in-depth knowledge of the market and its outlook, without a strong understanding of the fundamentals it is impossible to create a practical plan.
If you find that you are struggling to make a plan, with clear stages based on exit signals, then you probably shouldn’t be investing. Cullen gives this as his primary reason for steering clear of cryptocurrency, emphasising the importance of understanding the market you’re investing in.
Sticking to the Plan
The necessity of having a plan seems obvious, however, having the ability to stick to your plan is where it gets more challenging. The impacts of emotional decision making, confirmation bias, and even jealousy can make it far harder to exit a trade than you would expect.
Even legendary traders like Stanley Druckenmiller have fallen foul of emotion.
Druckenmiller lost George Soro’s Quantum Fund $3 billion in six weeks during the Dot Com Bubble, as the tech market crashed following an incredible run. He sold his tech shares in January 2000, at 104x earnings, but in March he bought back in after seeing younger investors continue to make gains, of course, he entered just before the market collapsed and lost his position. Despite his reputation for cold, logical trades, Druckenmiller got lost in the heat.
When asked what he’d learned from the experience:
‘Nothing. I knew I shouldn't do it. I was an emotional basket case. There was no lesson because I knew I shouldn't have done it. I just got caught up in it.’
Having a plan and, more importantly, sticking to it is the most effective way to make sure you don’t get burned when the market turns.
How to Create an Exit Plan
Cullen likes a balance of two types of exit signal:
- Technical considerations – the history of the bull market and its outlook
- Behavioural considerations – judging the mood of the market, who is interested in buying, who is exiting, and media hype
Technical considerations are of course market-specific, Cullen cites Andrew Weekly’s uranium exit strategy as a good example of using the history of a market to understand when to exit .
However, it is the behavioural considerations that Cullen finds most compelling, they involve an understanding of both the market and the people involved, here are some examples:
If popular media channels that don’t usually cover finance, think the BBC or Buzzfeed, start talking about a market it’s time to start scaling out.
Family & Friends
If the people you know, who aren’t traders, begin to ask about how to get into a market, then the market is probably close to saturation. Cullen gives the example of Bitcoin “if you’ve seen a taxi driver mention it, your mum asking you about it, then you really should be getting down to less than 25% exposure”.
If a frenzy starts to build on Twitter, with thousands of accounts talking about a market, then again, it’s probably time to start exiting your position.
Going Against the Grain
Look at unpopular markets objectively, don’t simply follow the crowd as you may be missing out on opportunities because of negative bias. Cullen highlights coal as a particularly good example of this; despite widespread disapproval, coal is a promising market with attractive dividends and a strong potential for growth over the next few decades.
It is a combination of behavioural factors and market fundamentals that underpin a good exit strategy. Behavioural factors are a key supplement to more a more traditional, data-based, approach, as they provide investors with a holistic understanding of a market. Cullen emphasises the dangers of ignoring market behaviour:
“You can be the best fundamental analyst in the world, and you can get everything right and still be wrong.”
Every market is full of individual-decision makers, and acknowledging their role in the outcome of your trade is essential to reduce risk.
The Final Word
Maintaining a rational mindset during an intense trading period is difficult for anyone, even world-class investors fall foul of their emotions, but planning your exits from a position is one of the most effective tools for mitigating these risks.
By combining both technical and behavioural factors into your plan you can gain a rounded understanding of the market, which will negate as much risk as possible whilst helping you scale out of a position at the right moments.
If a trader wants to be consistently successful then they need to accept that they cannot ride bull markets to the top, it is far too easy to get caught in the monkey trap.