Our good friends Carlene and David love to go to flea markets. They have a good time just walking around together and are truly excited when they find a deal.

We have a large flea market near our home, so several years ago we decided to all pile in the van and go check it out. Never having been to a flea market before, I didn't know what to expect. There was booth after booth of indescribable stuff. I walked around, enjoying the group fun, and then I saw it!

There was a small plaque with the message “Never test the depth of the water with both feet.” The minute I saw it, I knew I had to have it. I hadn't heard that saying in years. My grandfather had said it regularly when I spent summers on his farm in Ohio; he was attempting to teach me a few life lessons.

The plaque was $2, and I bought it immediately. Shortly thereafter, David scolded me. Apparently that's not how flea markets work; part of the fun is talking down the price. The fact that I'd have paid $4 was no excuse for not playing by the rules of the flea market game.

Applying Flea-Market Wisdom to Your Portfolio

The plaque now proudly hangs in our home in Illinois. Many times when I look at its little message, I'm reminded of how I should have heeded that advice long ago, particularly when it comes to investing.

On more occasions than I want to admit, I've bought a stock that was a “sure thing,” only to find it was quite the opposite. I would get myself into trouble with low-priced stocks that I thought were a steal. Wanting to make a killing, I would buy way too much because it sounded like such a terrific deal.

You know the story. Not only did I lose money, I lost a lot more than I needed to because I jumped in with both feet and made a major commitment. You can have a lot of profitable trades, but one biggie loss can erase all of those profits fairly quickly.

After one particularly bad experience, I decided to ask my mentor-broker friend if she had time for lunch. My question for her was simple. If you looked at the number of trades I'd made, there were more winners than losers. But at the same time, one big loser could easily clobber my entire portfolio.

What was I doing wrong?

When the Student Is Ready to Learn, the Teacher Shall Appear

My mentor-broker friend immediately scolded me a bit for not listening to her when I was buying stocks. More than once she'd cautioned me not to go overboard. You don't have to fund your whole retirement in one single trade; it just doesn't work that way.

After a bit of self-reflection, I realized that I was living in boom times, in my peak earning years, and I was much more flippant than I should have been. Most of the time, when I spoke with her on the phone (before the days of computer trading) I was between meetings and in a hurry. That's not a good environment for making investment decisions.

She suggested that, instead of jumping in with both feet, I consider diversifying. If no more than 5% of my portfolio was in one particular issue, even if it dropped in half, I wouldn't lose more than 2.5% of my overall portfolio.

If I quit trying to make a killing on one stock, I'd keep the nice winners and eliminate the potentially huge losers that could wipe me out.

As I walked by that plaque recently, I remembered the luncheon discussion. Her advice is still true today, and I realized how much more it means now that I don't have the benefit of time to recover from catastrophic losses.

Using Stop Losses to Check Yourself

My mentor-broker friend also introduced me stop losses. A stop loss is an order to sell a security when it reaches a set price; they're easy to set up.

The idea behind a stop loss is to set a limit on how much you are willing to lose. It's a way to register your loss-tolerance level when you're making thoughtful, levelheaded investment decisions.

In effect, they limit the depth of the water.

Whether or not you should use a stop loss depends on the security. If the issue is a heavily traded stock, you might want to set a fairly tight stop loss. If you use a stop loss on a speculative issue that trades only a few thousand shares per day, an aggressive market maker or an unusual blip could take you out of a position you want to keep. In those sorts of cases, you may decide that you're better off without one.

Preserving capital should be your first goal. If you never put more than 5% of your portfolio into any single pick and use a 20% stop loss, you've limited your loss to no more than 1% of your overall total.

“Trailing” stops are my personal favorite. Say you buy a stock for $10.00. At the time the trade is made, you also put in a 20% trailing stop. If the stock drops 20% to $8.00, a sell order is automatically entered, and you should be out of your position quickly.

Now imagine that instead of dropping, your stock increases to $15.00/share. The stop loss “trails” the price. Should the market price drop 20% to $12.00/share, the computer will execute a sell order, and you'll still end up with a $2.00 profit.

Stop losses are easily entered on most online trading platforms. It's important to consider the stock you're buying, what your expectations are, and how heavily it's traded before entering the stop loss. The stop losses you use may also vary depending on what else is in your portfolio.

I do most of my trading online with Schwab. When I enter a stop loss, I code it “good until canceled.” That really means “good for 60 days,” because the computer system will automatically cancel it after that. Instead of thinking of that as a hassle, I use it as a benchmark to review my position and re-enter the stop loss if I decide to.

My grandfather (and my plaque) said, “Never test the depth of the water with both feet.”

Now I'm adding to the maxim this bit: “A stop loss can easily define the depth of the water for you.”

On the Lighter Side

I tip my hat to Austin Rehkow of Central Valley High School in Spokane, WA, who kicked a 67 yard field goal to tie a football game with no time left on the clock. The YouTube video is terrific. A long field goal of 67 yards is quite an achievement; it's never been done in the National Football League.

While I'm discussing football, is anyone else tired of players dancing in the end zone every time they score? Hall of Fame player Walter Payton said players should act like it was no big deal, like they've been there before and do it all the time. He would normally just hand the ball to the official.

When I played, our coach emphasized not doing anything to disrespect the opposition, nor giving them an emotional event to rally around.

And finally…

A special “happy birthday” to my grandson Braidyn; he turned eight years old over the weekend. He had several friends over to celebrate; dad built a fire in the fire pit, and they roasted marshmallows and told ghost stories. They must have been good, because his little brother Brock went back in the house because he was scared; big brothers can do that to you.

Until next week…