Setting Stop Losses and Falling Markets

Your investments should never end up in freefall!
Your investments should never end up in freefall!

The average investor – and I mean the kind who wouldn’t bother to read this blog – never thinks about an exit strategy. He or she buys a stock because it looks promising, with plans to hold it until retirement or some other life event requires a large chunk of money. This “buy and hold” strategy is perfectly reasonable, except for the times that stock prices go down. Which happens a lot!

In fact, the average investor is more likely to sell too early, and miss out on profit. But sell too late, hoping the stock price goes back up. This is a bad, bad, BAD idea. An example:

Let’s say you finally succumbed to all the talk about people getting rich off the stock market, and in May 2007 you bought an S&P 500 index fund (an “ETF” fund designed to mimic the movements of the S&P 500 index) at around $151. By October, the crap hits the fan and the market starts a long, painful plummet to depths never before seen. All the while, you hope and pray it’ll turn around sometime. But this plummet is a deep one. Did I mention a painful one? It’s “the Great Recession”. At the depth of the plunge in March 2009, the SPY was valued around $69 per share. That’s a loss of 54%! The market did eventually go back up of course, but it wasn’t until January 2013 that the price of the SPY fund equaled your hypothetical investment of $151.

So what, hey at least it went back up, right? NO! That’s almost six years where your money was worse than useless. Your cash just sat around, not working, drinking beer and staying out late at night, contributing nothing toward your retirement. That six years might make the difference between which golf club you join in your retirement.

The horizontal line indicates your hypothetical $151 investment.
The horizontal line indicates your hypothetical $151 investment.

Imagine if, back in that fateful May of 2007, you said to yourself “Self, here’s what we’re going to do. The market’s still going to go up. Way up! To heights never before seen or imagined. I can feel it in my soul. But…just in case…if it ever falls from its peak, we’ll sell. Maybe 10% down. What do you think? Self? Now don’t cry, it won’t ever happen, it’s just an emergency ‘stop loss’ in case the unthinkable happens…”

The market peaked soon after your investment at around $155, and then fell and fell. But you summoned up the courage, and in January when it fell to below 10% of that, you sold.

Ok so you lost about $11 per share. And then you just sat and waited.

Then, shortly after the market hit bottom, it was back up by 10%. You had a little internal conversation again, and decided to get back into the market. Your 11$/share loss was soon erased and then some! So when January 2013 rolls around, you’ve made a gain of $81/per share. Sure you lost 7% on your initial investment. But you then just about doubled your investment on the way back up. 100% profit! You would have just been breaking even if you hadn’t gotten out of the market.

And keep in mind this was a fund that spreads the risk over many stocks. You might have gotten lucky and found a stock that didn’t fall quite as much. Or you might have picked a stock that simply went out of business, turning your investment into only a good story to tell your grandkids.

EVERY investor should have an exit strategy for when things don’t go as planned. My wife once said to me “you don’t believe in company X, so that’s why you want to sell.” I replied “no I do believe in that company and I think they’ll do great in the long term! But their stock is way down from the highs and I want the opportunity to make money on them twice!”

Since these are shares she bought, we are still negotiating this little issue….

Next post: how to actually set those stops, at least from this one guy’s perspective.


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