Congratulations! You just made your first stock trades and now you’re sitting back waiting for them to take off and make you a millionaire.
You see a few of them inching higher just like you had hoped, but one of your stocks is starting to fall. It is the moment of truth. Should you sell the loser and cut your losses? Is there a chance it will recover? What should you do if it doesn’t? One big loser can eliminate a solid year of gains — don’t let this happen to you.
The stock market slide in 2008 cost investors over $1 trillion in paper losses. This bear market has been the wake up call which reminds us of the risk inherent in the stock market, and more importantly, the need to protect our portfolios from major losses. It is impossible to predict what the market will do today, tomorrow or next year, but there is one thing that is definite: markets go up, they go down, and they stay the same.
There is so much information available about how to find the hot stocks, yet there is very little information available about how to handle the stocks you already own. One of the many overused market clichés is “Ride your winners and cut your losses.” However, this is one that must be followed. As an example, suppose you pick 10 stocks and invest $10,000 in each one. At the end of the first year if 7 of the stocks are up 10%, two are unchanged, and one has gone bankrupt, your $100,000 portfolio is now $97,000. That math doesn’t seem right at first: you picked 7 winners and only one loser. However, the math doesn’t lie. If you think only suckers hold stocks that go bankrupt, let me remind you of such blue chippers as MCI, KMart, Enron, GM and many others that were once huge stocks and now cease to exist. The rule of thumb is to limit your losses to 10% or less.
So in our example, if you had sold your loser at $9,000 (a 10% loss) instead of holding it to the bitter end, your portfolio would have been worth $106,000. The lesson here is that the stock market is full of risk and every dollar that you invest in a stock is at risk for a 100% loss. That doesn’t mean that you shouldn’t be investing in the market; it simply means that you should be taking every precaution to ensure that you minimize your losses.
Using Stop Loss Orders
When you buy a stock, there is a way to ensure that you minimize your losses on all of your trades. By placing stop losses on all of your trades, you virtually guarantee that your losses do not exceed a certain amount. A stop loss is an order placed with a broker to sell a security when it reaches a predetermined price or percentage. For example, if you buy Apple (AAPL) for $150 and you do not want to lose more than 10% of your investment, you simply place a stop order at $135. If Apple’s price drops below $135, your holding is automatically sold. Similarly, if you bought AAPL at $100 and it is trading at $150 then you currently have a nice profit of $50 a share, or 50%. At this point you can lock in your profits, and put in a stop order at $120 and enjoy the peace of mind. One advantage of using stop losses includes peace of mind; the ability to step away form your computer without worrying that you will lose your savings while you are gone and eliminating some of the inherent dangers of volatility in the market. Stop losses enable traders act with logic and discipline. Stop losses make sure you stay on track. If you always put a 5% stop on all your trades, you assure yourself that you will NEVER lose more than 5%. A stop loss is a straightforward, simple tool that allows traders to minimize losses, yet many people do not use them.
Take risk out of the market and practice using stop losses in your How The Market Works portfolio. So, what stop loss percentage should you use? William O’Neil, the founder of Investor’s Business Daily, has done lots of research on this topic and his recommendation is 8%. As soon as you buy a stock, immediately but a stop loss at 8%. Revisit that order every month and if your stock has increased in price, adjust your stop loss order accordingly. A more dynamic strategy gaining a lot of attention lately is from a company called SmartStops.net, founded by Chuck Lebeau. SmartStops provides both short-term and long-term stops that trigger when your stock or ETF fall into that range. Smartstops uses advanced mathematics that adjusts to follow an uptrend longer but quickly react to a downturn.