Portfolio Protection Step #2:
By Nancy Zambell
Editor, Investment Digest and Dividend Digest
In “5 Steps to Protect your Portfolio” the second step I talked about was the importance of setting stop-loss orders.
A stop-loss is simply an order—either formally placed with your broker—or a ‘mental’ reminder—to sell your stock when it reaches a certain price threshold.
It’s painless to place when you buy your stock through your broker’s website, or, if you prefer, you can just set an alert on whatever portfolio tracking website you use, so that if the stock reaches that price, you can make an instant decision on whether to cut it loose or keep it. That’s what I call a ‘mental’ stop.
I’m a big believer in stop-losses for one simple reason: If your stock doesn’t go the way you think it will (up in most cases!)—for whatever reason—this little tool will limit your potential losses.
Sure, it’s true that if you are diligent in the use of stop-loss orders, you can be stopped out of what could turn out to be a very good stock. But, you know what? You can always get back in, and more importantly—stop-losses can also save you money—as well as lots of sleepless nights—if market or industry forces cause your stock to take a nosedive.
The actual percentage you set is up to you, according to your personal risk tolerance. Very conservative investors may want to place their stops at a level that is 10%-15% below their purchase prices. Moderate risk takers would probably feel most comfortable setting stop losses at 15%-25% below their buy prices, and Aggressive investors who have a longer timeframe and the ability not to panic at short-term losses, may desire to set stop-losses at 25%-35% of their purchase prices. To easily determine your risk tolerance, take my Investor Profile Survey.
Here’s how it works: If you buy a stock at 3.00, and use a 20% stop, you would be stopped out at 2.40 (20% or $0.60 less than you paid for it).
In normal times, I often find that a 20% stop is sufficient for most stocks; up to 35% if the company operates in a fairly volatile industry.
But in a bull market, you may want to use trailing stops—stop-losses that continue to move up as your stock rises—rather than stops based on the absolute value of your purchase price. A trailing stop is more flexible than an absolute stop, as it continues to allow you to protect your portfolio in case the price of your stock declines. But as the price rises, the trailing stop is based on the new price, helping you to lock in your gains and reduce your overall risk.
It works this way: Using the above scenario. You buy a stock at 3.00 and place a 20% trailing stop. If the stock falls to 2.40, you are stopped out. But let’s say it rises to 3.50. Your new stop would be 20% of 3.50, or 0.70. So if the shares then fall to 2.80 (3.50-0.70), your stop will kick in. But now, you see, that instead of losing the 0.60 that you would have with the absolute stop, you only lose 0.20 (your original investment of 3.00 minus the stop price of 2.80).
I want you to know that there are plenty of advisors who don’t believe in stops, although not so many since the recent long and tough bear market, followed by a tremendous volatile market. But I believe that wise investors should use all the credible tools at their disposal. And I have found that stop-losses work very well for my subscribers and are great tools for stemming potential losses.
They’re easy to set, to monitor and to utilize. So do yourself a favor and don’t leave your portfolio unprotected!