You’re in a dark alley, and a man is coming at you with a knife. Now is the wrong time to start learning martial arts. Your chance to prepare is over. A dark alley is where you execute what you already know.
Before you read on, log in to your brokerage account. See any stop-loss orders? If not, today is the perfect day to set them up.
This has nothing to do with the market at large. Your portfolio is not the market. But it will suffer if the S&P 500 drops. Data show that markets crash together.
This is why we use stop losses for a big part of our portfolio. Not all of it: sometimes, alerts work better. And we don’t set any alerts on our core assets. We won’t be selling our gold anytime soon.
But with stocks, you need a way to cut your losses. This will put you ahead of the largest crowd in the market: retail investors like yourself.
Two facts to keep in mind:
- Households hold more equity than any other group.
- Humans are predictably irrational.
Data from the Federal Reserve backs up the first point: households held $12.5 trillion in equity assets in 2013. This is about as much as banks, insurers, foreign investors, pensions, retirement funds, and the government combined. Mutual funds, ETFs, and brokers hold almost one-third less equity than individuals: $8.6 trillion.
In short, retail investors are an incredibly powerful crowd.
This creates a ton of problems if you want to figure out where the market will go. But I’ll leave that topic aside.
Instead, let’s focus on the second bullet point. Your brain can destroy your wealth by making you sell winning stocks too soon and hold on to losers far too long.
But why? Don’t we all hate to lose?
Yes, but there is a caveat. You hate losses and avoid them at all costs. But once you lose money, your behavior changes. As your losses get bigger, you start embracing risk. The further down you are, the less you care. And that’s the problem.
Now, multiply the problem by $12.5 trillion. If a crisis approaches (not a man with a knife, per se, but almost as scary), some will panic and cash out. The retail crowd is nimble. It can get in and out of positions with a mouse click. A lot of others, though, will stick to their guns waiting for a turnaround.
Successful investors ride their winners and limit their losses for each investment. It takes discipline.
You don’t want to be erratic. You don’t want to lose too much. And you need to stay safe. So you need to prepare yourself.
Here’s how: set up stop losses.
Don’t sell out of panic or anxiety.
Don’t stick to your losers if a crash hits. You will need outside help, and a computer will help you stay rational.
You can stay safe through stop losses and position limits. Cap your positions at 5% per stock and set a stop loss at 20% of the latest price. Later on, adjust your stop losses to protect your gains. Then, if any of your stocks drop, you won’t lose more than 1% of your total portfolio.
Some people prefer alerts to orders. To be fair, we use alerts on some of our positions, too. In our monthly newsletter, we give case-by-case protection advice.
Bottom line: Don’t be blind to the possibility of loss. Be prepared.
We lay out our complete risk-control strategy in Money Forever Portfolio.