By Andrey Dashkov, analyst, Casey Research
The market is in bearish territory.
But that doesn’t mean you should panic.
On average, emotions are the main reason why investors earn below-average returns.
There’s a better way to put your money to work.
And that’s to control risk. Limiting your downside is paramount, especially in a bear market.
Below, I’ll talk about some of the time-tested ways of minimizing your losses.
These methods will help you navigate the stock market of 2022, which has so far surprised even the most sophisticated investors.
Limit Your Exposure and Leverage
You know the old adage: never bet the farm on any trade.
In practical terms, limit your exposure to 5% of your total portfolio for a blue-chip stock and about 2% for a small speculative position.
Emotions can undermine this simple rule. If an investment idea sounds great, you might want to go all-in.
You can win only if you spread your bets.
That’s how venture capital funds work. Even though every start-up can potentially become a unicorn, they never put all their capital into one company. Ever.
Yes, if you limit your positions, your upside will be limited. One “unicorn” will never add a zero or two to your whole portfolio.
But if you spread your bets wisely, you will not see catastrophic losses, either. That’s the number one goal.
The riskier an investment is, the less capital you should commit to it.
And as an extension of this… be careful with leverage.
As a reminder, “using leverage” means borrowing money to invest.
Yes, adding some leverage to your positions will increase your gains if things go in the right direction.
But if they don’t, you will risk losing way more than necessary.
For example, if you buy 100 shares at $10 per share with your own money, you put $1,000 of your own capital at risk. (We will ignore taxes and commissions here for simplicity.)
But let’s say you borrow another $1,000 from your broker and bought another 100 shares.
If the stock price goes to zero, you will lose $1,000 in the first case and $2,000 in the second one. Your cash position will be gone, and you will be $1,000 in debt.
Investors using leverage can lose more than 100% of their money.
That’s why in a bear market, I don’t recommend using leverage at all.
Use Stop-Loss Orders and Alerts
Sometimes markets crash. And continue crashing.
To survive those moments, you need to have stop-loss orders in place.
Think of them as free insurance against massive losses.
A stop-loss order tells your brokerage that you want to sell this stock if it falls, say, by 20%.
Trailing stop-loss orders are the best. The “trailing” part means that the stock price that the order is based on is kept up to date.
So, for example, if a stock climbs from $10 per share to $12.50, the stop-loss order of 20% will be based on $12.50.
And if it falls back to $10, which is a 20% decline, your stop-loss order will be triggered, and you’ll end up losing nothing. The order will be triggered because of the 20% price decline off the higher price, $12.50.
You’re back to square one with some cash available to invest in other opportunities.
However, there is a caveat. Stop-loss orders work best for mid- and large-cap companies.
They don’t work well for small and illiquid investments.
But that’s where stop-loss alerts come in.
If you’re a Strategic Investor subscriber, we use stop losses on several of our positions. And we always send an alert if one is triggered.
If you’re not, there are quite a few services that allow you to set up alerts when prices on the investments you hold hit a certain level.
Tradesmith is a good one. It’s what we use at Casey Research. Or you can check with your broker to see if they offer a similar service. Most popular brokerages do.
Alerts are a great way to stay aware of what’s going on in your portfolio, especially if you hold a lot of small-cap and speculative investments.
I hope these tools help you control risks and increase your returns simply by limiting your downside.
Analyst, Casey Research
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Check it out right here.