Thursday, January 12, 2012

Portfolio Protection Step #2: Stop-Losses—Don’t Leave Home Without Them!

In my recent article 5 Steps to Protect Your Portfolio | InvestorPlace, 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 web site, or, if you prefer, you can just set an alert on whatever portfolio tracking web site 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 your bacon if market or industry forces cause your stock to take a nose-dive.

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 time frame and the ability not to panic at short-term losses, may desire to set stop-losses at 25%-35% of their purchase prices.

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, in this case, 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. And while I think we are nearing the timeframe when the incredible volatility owe saw last year will lessen, the market may still have a few surprises in store for us, so I would rather be a little conservative right now.

From time to time—especially in a bull market—you may also want to adjust your stop, using trailing stops—stop-losses that continue to move up as the of your stock rises—rather than stops based on the absolute value of your purchase price. But since I don’t believe that we are yet in a raging bull market, I would recommend that you continue to use absolute stops.

I want you to know that there are plenty of advisors who don’t believe in stops, although not so many since this 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 have worked 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!

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