Carnivals - For Week of 9-3-07

Teaspoon Finance posts appeared this week in the following Carnivals. I picked my favorite post at each carnival:

I encourage you to stop by and find your favorite personal finance posts.

Your Personal Stock Market Army - The Stop Loss!

Stop losses can bring you peace of mind, profit, and minimize your losses.  If you own stocks right now and don't know what a stop loss is, then I encourage you to sit a spell, grab some coffee or tea, and sip of this important information. If you own stocks right now and know what a stop loss is, I sure hope you're using them.  If not, then please stick around for a spell.

I had a friend many years ago that was complaining about his troubles investing in stocks.  He never seemed to make a decent profit on winners and he always seemed to collect a bunch of losers and never knew when to get rid of them.  I told him I'd listen to his troubles and offer advice where I could.  He had close to a million dollar portfolio invested in individual stocks.  Man was I envious of his assets!  But, not of his investing skills.  I asked him a simple question: "Do you have sell prices or sell ranges for all the stocks you own?".  His answer: "Not on a single one."  He allowed the market and his financial needs and emotions dictate when he would sell something.  After our couple hour discussion, of basically what you'll be hearing below, he vowed to have stop losses set on all of his stocks within the next week.  Note: at that time, there wasn't such a thing as trailing stop losses available on most online broker sites, so now days it's even easier!

I've heard his thanks many times since for introducing him to the power of the stop loss.  You definitely want to get educated on the stop loss as your most important weapon in the war of personal finance with respect to stock investing. Keep in mind this is stocks, not mutual funds. With mutual funds, you are diversified. With stocks you are putting all your eggs in one basket, as they say. This can be a very risky proposition and you need some protection. Sometimes you need protection from yourself, and your ability to rationalize and accept deeper and deeper losses. Here's where the stop loss comes to the rescue!

What is a stop loss? Here's a quick definition from wikipedia:

With a stop order, the customer does not have to actively monitor how a stock is performing. ...Once the stop price is reached, the stop order becomes a market order. ...A sell stop order (also stop loss order) is an instruction to sell at the best available price after the price goes below the stop price. ...This can limit the investor's losses (if the stop price is at or below the purchase price) or lock in some of the investor's profits.

There are 2 types of stop losses at many brokers and online brokers now:

  1. Traditional Stop Loss
    Traditionally with the stop loss, you would select a price point at which you wanted to sell if the market price went below that price. If this is the only kind available at your broker or online broker, then please do use it. The use of the traditional stop loss might require a little extra maintenance on your part, as you monitor and decide to ratchet it up to lock in profits or limit losses.
  2. Trailing Stop Loss
    The traditional stop loss requires regular maintenance if your stock price is on the move and you would like to efficiently lock in profits or further limit your losses. It's great that brokers have added the trailing stop loss as an option with brokers and online brokers. This allows you to set a stop loss margin that will follow an increasing price. You typically have the option of choosing a trailing stop loss by $Dollar Amount or by %Percentage. I love this, because you can choose to follow a rising stock price with a trailing stop loss of for example: 5%. That way, as a stock price continues to rise, you'll be locking in a profit that is 5% below it's high price. The 5% gives the stock enough room for volatility as well as ensure that your locked in profit continues to rise.

I propose that you should never own shares of stock without having a stop loss placed on them. Quite simply, it is human nature to keep accepting a lowering stock price without selling. You begin to rationalize at every new red flag in the lowering stock price: the news just isn't good, I know they'll be announcing a new product soon, people just don't know enough about them yet, stock prices generally go back up, I'll just wait till I get back to even and then sell, etc.

We should be quite the opposite with stock investing, we should not be emotional. We should think of stocks as a vehicle for our investments, and one stock is just like the next. There is nothing magical about the current stocks you own. If they are losers, then get rid of them, learn and improve your stock picking rationale and pick again. If you have winners, learn aspects for picking winners. Lock in profit for winners. Don't allow winners to become losers, because you got attached emotionally because it used to be a winner.

I encourage you to learn a method of picking and evaluating stocks that works for you. For me, it's CANSLIM. CANSLIM defines a method of evaluating and picking stocks and was created by William J. O'neil. I recommend you to look at these books in the library, bookstore, etc: How to Make Money In Stocks and The Successful Investor: What 80 Million People Need to Know to Invest Profitably and Avoid Big Losses.

Again, i propose that you should never own a share of stock without protecting it with stop loss. I'll break that down to 3 three powerful reasons for having a stop loss:

  1. Limiting Loss
    When you own a stock, you should do some regular self assessment as to what is a reasonable loss you would accept for the stock. Whether you do this weekly, monthly, quarterly, just do it regularly. Once you set your stop loss, you have now protected your investment from a pre-determined loss. This is key, because human nature would have us complacent and rationalize a declining price at every turn with the hope that the price would soon recover. But, by thinking ahead of time, you take this emotional and fear based thinking out of the equation and treat an investment in a proper way, as a vehicle of investment. You take the time to think rationally about what amount of loss you are willing to accept if a stock moves against you. You limit the loss, because you take out the changing emotions that will occur as that stock becomes a loser and you would inherently start rationalizing the losses. I don't care if you're a long term investor or short term. If you're long term, then you'd just increase the margin of your trailing stop loss to not be triggered by normal volatility.
  2. Locking in Profit
    When you are lucky enough to own a stock that is appreciating in value, you should be protecting that growing profit. I used to ratchet-up my stop loss on a weekly or monthly basis as stocks kept growing in value. Now days, they have an awesome new kind of stop loss, they call the trailing stop loss. This means you can set the stop loss to trail the rising price by a dollar amount or a % amount. This is an absolutely powerful feature!
  3. Peace of Mind
    Probably the most important benefit of the stop loss is the peace of mind you'll enjoy. You'll sleep peacefully every night. You'll feel at ease throughout the week, without submitting to the need to check your stock prices hourly to see if you are ahead or moving behind. This is all because you put in place your hard working army of individual stop loss soldiers on each of your stocks.

I love free money with ESPP's. If you have an ESPP available at your employer, this is like free money and the stop loss can maximize your profits and limit your loss of profit. What I do, is every time my employer buys my ESPP stocks, I immediately (the day it becomes avail in my broker account), go in and set up a trailing stop loss of 3%. I encourage you to adjust your %percentage based on your stocks volatility. 3% for my employers stock works perfectly. If the stock keeps rising, then I keep locking in more and more profit. As soon as it turns around, it's sold for me automatically.

I also do this when I have lost confidence in a stocks upward momentum (can be due to market news, stock news, etc.) and it begins to move sideways. I'll reduce the % of trailing stop loss, to still gain from upward momentum and at the same time press the sell sooner than later.

If you didn't hear me before, I'll close with the same thought: I propose that you should never own a share of stock without protecting it with a stop loss. You'll benefit greatly from the peace of mind in your daily life, knowing that you put in the up front thought and made decisions on what loss you are willing to handle for each of your stocks. You'll feel at peace that you're profits are automatically being locked in as your trailing stops chase after a rising price.