Let's assume you found a stock that meets all of your criteria and fits our checklist. Before you pull the trigger, we need to discuss your relationship with this stock.

That's right, whenever you buy an equity, you enter into a complex relationship -- with the stock, the company, its management, even your fellow shareholders.

Before your purchase, you are still in a flirtatious stage -- you have no history with the stock and therefore no baggage. That's the time -- before you get in too deep -- to lay out some ground rules governing this relationship.

What you need is a pre-nuptial agreement with the stock.

There are several reasons to create a document governing your affiliation with a stock.

The first is objectivity: Once you own something, you lose the ability to take a cold-hearted look. You've become invested in the company, literally and figuratively.

After you've (hopefully) invested serious time and energy before deciding to make a purchase, you become emotionally invested in the trade. Emotions are the flip side of objectivity, and they rush in to fill the void when objectivity is lacking. A stock isn't Old Yeller, but you would be surprised at how hard it is to make a clean break. (A prior column detailed the danger of emotions.)

By having a clearly defined set of parameters regarding how long you are going to hold the stock, and under what circumstances you will "file for divorce," you avoid making emotional decisions to either sell too soon or not at all.

The second reason is discipline, one of the keys to successful investing. All traders know that without discipline, even the best investment plan is worthless. In the classic investing book Market Wizards by Jack Schwager, the theme of discipline comes up repeatedly in interviews with traders of all sorts: commodities, stocks, currency, futures and fixed income.

Unfortunately, far too few investors actually have any. Indeed, whenever we hear of some hedge fund that blew up, you often hear a manager lament, "If only we had stuck to our discipline." The pre-nup is a way to ensure that you avoid that fate.

Third, and finally, you want a record (paper or computer) of what you were thinking before entering this investment. We're all too capable of rationalizing our actions after the fact. I've heard investors come up with every excuse in the world to hold a dying position rather than admit they were wrong and move on. The pre-nup helps to eliminate that counterproductive behavior.

The Terms

A good pre-nup should answer the simple question: What are grounds for divorce?

  • Performance (bad): There are three objectives in jettisoning a poorly performing stock.
  • First, a recognition that you may have been wrong. For whatever reason, the trade simply didn't work. Perhaps it was the timing, or merely a case of bad luck. By having a strategy to cut your losses, you can redeploy capital more productively.

    Second, avoiding the debacles -- the Enrons, Nortels ( NT) or Lucents ( LU) of the world that whither away to become single digits, or zeros. Avoiding these disasters with only minor losses goes a long way toward keeping your portfolio healthy.

    Third, a disaster stock can easily dominate an investor's psyche. If you become totally wrapped up in a bad trade, it interferes with your ability to do anything else productive. Think back to how many people didn't even bother opening their statements during the 2001-2003 period. That's how debilitating major losses can be -- and why avoiding them is so crucial.

    In the near future, we'll look into a few stop-loss strategies that will help you in preparing the pre-nup. The key is to have a written explanation of what will trigger a sell in advance.

  • Performance (good): How long are you going to keep a stock that's making money? Under what circumstances will you take a profit? What if it becomes a huge winner -- at what point will you rebalance your portfolio?
  • While many people are concerned about what to do with a loser, they often forget that you need to plan for how to handle a winner. I employ a few strategies for dealing with this. First, I like to watch the uptrend -- if and when that's broken, that's certainly a good reason to sell some of the position.

    Several successful traders I know use a simple 20-day moving average; when that cracks, they take profits. Another strategy is using the prior month's lows -- anytime a stock that's been moving higher breaks the previous month's lows, it's a sign that the trend may be over. This method can keep you in a strongly performing stock for several years.

    Lastly, if a big winner gives back more than 25% of your gains, you may want to protect the rest of those profits by selling the stock.

    Before you select one of these methods, play with them to see how they fit you style. Back-test these tactics to see how long they would have kept you in the few stocks that have been working this year -- the homebuilders, defense plays or integrated oils -- and where you would have gotten out of tech and Internet names from the 1990s. The key is finding a methodology that works for you.

  • Original rationale: Once the underlying reason that prompted you to buy a stock goes away, sell the holding. Period.
  • For example, earlier this year I thought there was a good chance that Blockbuster ( BBI) was going to merge with Hollywood Entertainment. Carl Icahn had accumulated a large chunk of stock in both companies. A turnaround story, a billionaire investor and a merger meant there was potential upside for a name widely disliked by Wall Street. After a competitor, Movie Gallery ( MOVI), won the bidding war for Hollywood Entertainment, it was apparent that plan was not coming to fruition.

    With my original reason for owning the stock gone, I had no choice but to sell the stock for a small loss. A month later, bad news hit, sending Blockbuster down 30%.

    This is a hard and fast rule of mine: Never hold anything once your original reason for ownership disappears. Whatever other reason you come up with is only an after-the-fact rationalization.

  • Fundamental changes: When the fundamentals change for the worse -- and you've defined this in advance -- that's as a good a reason to sell as any. Unfortunately, by the time most investors realize that the fundies have changed, the stock is usually significantly lower. This is typically the worst reason to sell, timing-wise. But you can often avoid even more bloodshed by exiting the stock, especially if its entering a cyclical period of poor performance.
  • Time: How long are you going to wait for this dog? You simply want an understanding -- in advance -- of the period of time you will be willing to wait for a stock to produce.
  • If a company is a slow grower with a good dividend, you might be willing to give it awhile -- even a few years. If it's a potential explosive grower awaiting a key catalyst, you might be less patient, giving it only a few quarters. Some trades may get a 90-day grace period, or less. But decide before you own it.

    For Better or Worse

    A marriage pre-nup is designed to protect your assets before the honeymoon begins. Experience suggests that once the dishes are being thrown, having an objective, unemotional discussion about who gets what is all but impossible.

    The same thought process governs the stock pre-nup. It's designed to maximize your retention of assets in the likely event of an ugly equity break up. And it doesn't even need a lawyer!

    1. Expect to Be Wrong 2. Your Fault, Reader
    3. The Wrong Crowd 4. Bull or Bear? Neither
    5. Know Thyself 6. Prepare for Battle
    7. Bite Your Tongue 8. Don't Speak, Part 2
    9. The Zen of Trading 10. The Folly of Forecasting
    11. Lose the News 12. Tracking Elephants, Pt 1
    13. Tracking Elephants, Pt 2 14. Nothing Doing
    15. Surviving Silly Season 16. The Zen of Trading
    17. Curb Your Enthusiasm 18. Six Stocks
    19. Bended Knee 20. Time Waits for No One
    Check back for more of Barry Ritholtz's
    Apprenticed Investor series

    TheStreet.com has a revenue-sharing relationship with Amazon.com under which it receives a portion of the revenue from Amazon purchases by customers directed there from TheStreet.com.

    Barry Ritholtz is chief market strategist for Maxim Group, where his research and market analysis are used by the firm's portfolio managers and clients in the U.S., Europe and Japan. He also publishes The Big Picture, his macro perspectives on the economy and geopolitics, entertainment and technology industries, and is a member of the board of directors of Burst.com, a streaming media software company. At the time of publication, Ritholtz had no position in any securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Ritholtz appreciates your feedback; click here to send him an email.

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