By John Waggoner, USA Today
One definition of madness is doing the same thing over and over, and expecting different results. If you have tried to snatch up a cheap stock in the past six months or so, you're probably questioning your sanity. Cheap stocks just keep getting cheaper.
For people who like bargains, stocks remain tempting. Many stocks are lower now than they were a decade ago. Before you decide to dive in again, however, make sure you have an exit strategy. You'll save yourself some money and, sooner or later, you might lose that twitch.
For many years, selling a stock was considered something that was Not Done, like bringing a clown to a funeral. After all, stocks always went up. Patience was the only answer to a stock tumble.
These days, however, those who hesitate are often lost. Say you bought 100 shares of Bank of America on Dec. 31 at $14.08. Price: $1,408.
You could have argued that Bank of America, the nation's third-largest bank holding company, was a cheap stock. It had already fallen 63% since Oct. 1. And it sold for 2.3 times its estimated 2010 earnings. (The price-earnings ratio, or P-E, measures how cheap a company's stock is relative to its earnings. The higher the P-E, the pricier the stock. Bank stocks typically sell for lower P-Es than most other stocks, but 2.3 is still inexpensive.)
Cheap or not, BAC wasn't a great buy. By Thursday, BAC closed at $3.93 a share, meaning you have lost $1,015, or 72%. In short, you've suffered a devastating loss: To get back even after losing 72%, you have to gain about 270%.
Ideally, you'd like to sell before taking such a huge loss. But how do you decide when to sell a stock?
Dan Chung, chief investment officer for the Alger funds, has a few general rules about selling. If the company produces a startling earnings disappointment, for example, you should consider selling, he says. You might also consider selling if you think another stock has better potential.
But you should also set a limit on how much you are prepared to lose the moment you buy a stock. One way to make sure you stick to that limit is to use a stop-loss order, which tells your broker to ditch the stock if it falls to a specific price.
You can put in a new stop-loss order every day, using a day order, or you can specify that your stop-loss will be good until you cancel it. (These orders don't last for all eternity; depending on your broker, they may last only six months or so.)
The next question: Where should you set your stop-loss order? In most cases, setting the stop at a 10% loss makes sense. You'll have to earn 11% to get back even, but an 11% loss is not a fatal error. Had you set a 10% stop on your Bank of America investment, for example, you'd be out about $141, plus commissions, rather than $1,015.
A stop-loss might not help in all circumstances. If your stock is down 10% when the Standard & Poor's 500 is down 15%, for example, it's holding up reasonably well. Some highly volatile (and low-priced) stocks will move up and down 10% pretty frequently. And, inevitably, you'll have some stocks that fall 10% and promptly rebound.
"Basically, we're talking about controlling risk," says Chuck LeBeau, director of analytics for SmartStops.net, a website that tells you when to sell. When you buy a stock, LeBeau says, you can't control how much it will go up. But you can limit your losses by using a stop-loss order.
SmartStops.net uses proprietary formulas, based on a stock's general direction and its volatility, to determine when to sell. The stop recommendations change every day. You can monitor a portfolio of three stocks or exchange traded funds for free, or get five stop recommendations a day for free.
If you're thinking of selling a mutual fund, which is typically a longer-term holding, then you need to examine the fund's record against other, similar funds over time. By and large, if a fund has lagged behind its peers for the past one, three and five years, it's time to ditch it. The chart shows five funds with assets of more than $1 billion that fit the sell criteria.
One place to get further guidance: The website FundAlarm, which is aimed at telling you when to send your fund to Palookaville.
Many investors have been burned enough by this market to sit on the sidelines for a while. If you're brave, or even mildly mad, be sure to have a sell point in mind the moment you buy.
John Waggoner is a personal finance columnist for USA TODAY. His Investing column appears Fridays. new book,Bailout: What the Rescue of Bear Stearns and the Credit Crisis Mean for Your Investments, is available through John Wiley & Sons. Click here for an index of Investing columns. His e-mail is jwaggoner@usatoday.com.
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