In my recent article, 5 Steps to Protect Your Portfolio, the second step I talked about was the importance of setting stop-loss orders.
Portfolio Protection Step #2
A stop-loss is simply an order — either formally placed with your broker or a mental note to yourself — to sell your stock when it reaches a certain price threshold.
It’s painless to place a stop-loss when you buy 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, for whatever reason, your stock doesn’t go the way you think it will (up, in most cases!), 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 nosedive.
The percentage fall 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% to 15% below their purchase price. Moderate risk takers would probably feel most comfortable setting stop-losses at 15% to 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 their stop-losses at 25% to 35% of their purchase price.
Here’s how it works: If you buy a stock at $3 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 time frame when the incredible volatility we saw last year will lessen, the market may still have a few surprises in store, 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.” Those are stop-losses that continue to move up as your stock rises rather than stops based on the absolute value of your purchase price. But since I don’t believe we are in a raging bull market just yet, I would recommend that you continue to use absolute stops.
I want you to know that there are plenty of advisers who don’t believe in stops, though not as many as there once were since this recent long and tough bear market settled in, followed by a tremendously volatile market. But I believe wise investors should use all the credible tools at their disposal. 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, easy to monitor, and easy to utilize. So do yourself a favor and don’t leave your portfolio unprotected!