Protect Profits by Having a Plan

Thursday, December 15, 2011
Michael Kahn


After the last two bear markets, most investors understand that they have to have a plan to protect their portfolios. Traders live and die by this. They are taught that knowing when they should sell is more important than when to buy.


In other words, they recognize when it is time to cut their losses. Investors should understand this, too.


How many of us are guilty of thinking that a lower stock price is always a better value? This was the case in November 2007 just after the last bull market peaked as analyst forecasts were still rather rosy. And during the 2008 bear market it was also the case, as we often heard news reports that "the financial crisis is near its end" or that "housing is about to bottom."


Were all the profits you booked over the 2003-2007 bull market protected? Did you have a plan to take at least some money off the table when it became clear that the market was no longer healthy?


The market usually gives off many signals when the good times are about to end. One example is deterioration in market breadth, when the average stock starts to stumble well before the major indexes peak. Stocks with marginal fundamentals are left behind, unlike in bull markets when investors buy anything and everything.


Another example comes from the rising trend itself. In a healthy bull market, the general direction of the market is clear, even with the normal sequence of rally and pullback. However, when the rallies start to shrink and the pullbacks start to grow, we can get a good idea that the trend is changing.


For most investors, knowing what to watch and having the time to watch it can be a problem. Therefore, they need a more mechanical plan.


How do investors create such a plan? A tool called a "stop" or "stop loss" order is one way to help mitigate losses. Basically, you determine how much money you are willing to lose on any investment - how much you are willing to risk - and if the stock reaches or surpasses the price you specified, an order will trigger to sell. Stop orders allow you to ride an upswing and limit your losses on a downswing even if you're not watching the market every minute.


If you just bought the stock, you take your loss and move on.


If you owned it for a while and you have a profit, you set your stop based on today's price, not the price you paid. You may still walk away with that profit, but keep in mind that once the order triggers, it becomes a market order and could execute well below your stop price if the stock takes a sharp drop. Using stop orders can be an excellent strategy to prevent loss, but it can also be very unpredictable if the market or the stock is particularly volatile.


Remember, big losses can begin with small losses.


While it is always possible that the stock will rebound, causing you to sell a good investment, you can help mitigate losses during a bear market with carefully placed stop orders. You are managing your risk. And you will live to invest another day.


No matter which way you think the market is heading, if you own stocks you must know what has to happen to cause you to sell. Sometimes it is a change in the fundamentals, and other times the market reacts in advance to tell you something is wrong. That will be the time to consider managing risk rather than seeking that last nickel of profit.