Every rational investor realizes that it is foolish to expect every buying decision to be correct. If we acknowledge that not every decision will be correct, it becomes important to define, in advance, what being incorrect looks like. That definition is your exit. There are a lot of ways to do this, but designing an exit strategy should take a few things into consideration:

• It should make an allowance for normal volatility
• It should be integrated with the entry strategy
• It should be a repeatable, systematic process
• It should provide for an asymmetric return profile

Generally speaking, we want to exit positions that are declining, but before that decline does too much damage. At the same time, we want to prevent acting on a meaningless price move that is within the normal range of fluctuation. For this reason, making an allowance for normal volatility becomes important in reducing the number of transactions and keeping you in an uptrend for as long as possible.

Integration with the entry strategy is vital. Controlling losses by getting out of a falling market is important, but deciding when to get back in can be even more important. If your approach is to follow trends, then a simple trailing stop could be problematic – what if the position you exited is still in the uptrend? How would you re-enter? If your approach is fundamental, an exit designed to protect capital may occur while the fundamental basis for purchase remains intact. How do you re-enter? There has to be a cohesive strategy that addresses the potential conflict between a protective exit that occurs while the reasons for buying remain in place.

Without a systematic process in place to make decisions, you will never know whether or not your results are repeatable. Data gleaned from backtesting will be misleading and invalid. Decision making discipline will be impossible to enforce since, by definition, a non-systematic approach is one based on intuition. The only way to build a robust exit strategy is to execute it the same way every time, acknowledging in advance that there will be an error rate. Getting out won’t always turn out to have been the right decision. That’s OK. Portfolio management shouldn’t ever be about a single decision, but about an accumulation of decisions over a long period of time.

An asymmetric return profile is one that provides downside protection while leaving the upside unconstrained. Rather than focusing on trying to make every investment a winner, the more profitable approach is in recognizing and cutting losses quickly, while they are small, but allowing the wins a chance to grow and become meaningful. It is perfectly fine to take losses, in fact it is necessary, but only if the exit strategy allows the magnitude of the wins to overpower the impact of the losses.

Next up, Step 4: Position Management