Setting target prices 2 comments

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One is often advised to have a target price in mind before buying a stock, and to have the "trading discipline" to sell the stock once it reaches that target price. This approach does impose a certain trading system on the rookie investor, but certain aspects of this advice do run contrary to other conventional wisdoms which then confuses him.

Firstly, setting a target price is good for deciding whether the stock offers potential high returns for the investor. Say, if the investor assesses that there is 50% upside ie. the target price is judged to be 50% higher than the current price, then clearly there is high return. However, if the decision is taken in isolation through consideration of the target price alone, clearly the other important factor is forgotten: the probability of the stock being able to appreciate to that "target price" (this could depend on many factors: institutional ownership, macroeconomic trends, earnings risks etc).

Secondly, how does he set the target price? If he decides he will set it at say, 20% above the current price, a conservative trading technique, it doesn't make sense because this is too arbitrary and clearly the market doesn't care what price this particular investor bought at. A more logical method is to set the target price at a certain target PE representative of the sector the stock is in. However PEs are never static; a stock can be trading at 10 times PE during a declining economy and be considered expensive or it can be trading at 15 times in a recovering economy and be called cheap.

Thirdly, does one sell the moment the original target price is reached? It is good "discipline" to do so but surely practising this is a form of "stop profit" technique?? (adapting the "stop loss" terminology).

One of the most well-known adages is to let one's profits run, and indeed this should be practised. The idea is to remain abreast of business developments affecting the stock in question and to have a dynamic, rather than static, evaluation of its "target price". The role of psychology and momentum in the stock market should not be discounted; often prices go higher than expected as people get excited about a certain sector or stock. A pragmatic view of "target price" should be evolving in real-time with price developments (as opposed to business developments which gave rise to the original price target) and take into account such human factors. Perhaps one good way to exercise profit-taking discipline after the breaching of the original price target would be not to sell immediately, but rather to sell on the first significant show of price pullback, say 5-10% retracement. This is a combination of stop-loss and profit-taking, with the final transactions being exercised at prices above the original "target price".