Stupid Investment of the Week

Stupid Investment of the Week

Commentary: Find a stop-loss point before you go any further with stocks

By Chuck Jaffe, MarketWatch


BOSTON (MarketWatch) -- Maybe you're investing because you believe that stocks are "on sale," or perhaps it's because you believe in the long-term prospects for recovery. Perhaps you hold stocks that have been good to you in the past, or which you've been in so long that you don't want to go through the headache of calculating your capital gains.

Or you could be trading for a quick profit, or following the discipline of dollar-cost averaging.

Whatever the reason, if you haven't come up with a stop-loss point -- either a real trigger to get out of an investment if it falls too far or an emotional point where you would sell -- you're making the Stupid Investment of the Week.
Stupid Investment of the Week typically highlights conditions and characteristics that make a security less than ideal for average consumers, focusing on one example to showcase common pitfalls.
This week, however, the trait under review belongs to the investor and not the investment. Specifically it's about people who buy or hold a stock in a trader's market without having a concrete exit strategy.
"The hardest thing investors have to do is to determine when they can make money in this kind of market, and when they have to preserve capital, because those things are often at odds with each other," said Richard Geist, head of the Institute on the Psychology of Investing.
He added: "You are looking at something saying 'It's a bargain,' or feeling like it can't go down much further from here, and yet you are also looking at your portfolio and wondering how much of a loss you can take if you are wrong."

Set limits

There are plenty of stop-loss strategies, typically involving a standing order to sell shares if they fall to a specific level. That said, rigid stop-loss programs typically are wrong for casual investors, as they can trigger losses again and again, especially in a volatile market.
So while many investors who follow trading systems will always set a stop-loss at, say, 8% or 10% down from their buying point, an average investor could find themselves with a slew of investments all delivering a quick loss and never reaching the longer-term prospects that are behind the holding.
"A trader or someone with a system basically is using stop-losses to avoid being wrong," said Ken Shreve, markets desk anchor for Investor's Business Daily. "Someone who buys and holds blue-chips, they're trying not to be concerned with the short-term losses, figuring that they will get paid off over time."
But, he added, "At some point, however, those losses start to add up and the math is not on your side. The problem with riding things down is that a 50% loss in a stock requires a 100% move back up. ... The math is the best argument for basically setting a selling point, one where you avoid losses or protect your gains."
For long-term investors, finding a selling point may not mean setting a stop-loss order at a specific price per share. Instead, it may be an emotional price, one where the investor says they are willing to gamble with some of their winnings, but they are not going to allow a long-time winner to morph into a long-time loser.
Unlike the person with a trading strategy, who takes proceeds from a stop-loss trade and puts it toward the next investment that meets their buying profile, a long-term buy-and-holder is looking more to create their reason to get out the door, without regard to the next investment. They are more concerned about protecting what they have than finding a faster horse at the track.
Consider General Motors (GM) , which was trading 12 months ago north of $26 per share. At that price, there were still plenty of long-term believers, employees and former workers with huge slugs of stock in their retirement plan and more. While the market was waking up to the problems that have led to the company calling for a federal bailout to avoid bankruptcy, the long-term, 'I-have-faith-in-America, it's-too-important-to-fail' crowd was hanging on, and their accounts were being slaughtered for it.

Avoid the worst

Likewise, the financial services industry spent the late 1990s and early 2000s rewarding investors many times over, and yet a long-term holder who simply figured "things couldn't get much worse" basically has watched decades of gains evaporate.
Behavioral finance experts say that investors tend to go through a progression that includes some measure of denial about just how bad things can get. When they wake up to horrendous losses, they are looking at account balances so low that they may ride things out until the bitter end.
Instead, Geist noted, they should have a mental selling point, one where they say they will allow that long-term winner to shrink back to maybe double the initial investment or all the way to break-even, but that when it reaches those scary levels it gets sold in order to avoid the possible bitter end.
This "emotional stop-loss" is just as important as the actual trade; effectively, it is like setting your limit at the casino and saying "this is the point beyond which I need to stop gambling."
And while some of the issue is based on emotions -- the point where you start losing sleep at night based on the shrinking value of your biggest holdings or your entire portfolio -- some of the decision will also be based on your needs and plans.
"The more stress people are under, the worse their decisions tend to become," Geist said. "So if you are holding something today and you know there is a point where enough is enough -- where you just can't take more loss or you just have to acknowledge that whatever had you buying or holding the stock just isn't working right now -- that point becomes your emotional stop-loss. If you know it in advance -- and setting it is the hard part -- it will protect you from letting things get worse while you try to figure out if you should hang on or not."

Chuck Jaffe is a senior MarketWatch columnist. His work appears in dozens of U.S. newspapers. www.marketwatch.com
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