Two Easy Ways to Avoid Disaster in Your Portfolio

Dr. Sue isn't stupid...

She's a rare – almost unheard of – triple-boarded physician. And she trained at Johns Hopkins University – one of the most prestigious places where you can study.

And yet, she almost lost more than half of her savings thanks to one critical mistake. Let me explain...

In the 2000s, Sue and her family were scoring big on small Chinese stocks.

But when the markets crashed in 2008, Sue made a fatal error that I've seen ruin portfolios... As her investments collapsed, she wouldn't sell. By the time she asked for my help, her portfolio was already showing losses of 80%, 93%, 95%, and so on.

She lost more than $50,000 because she didn't use stop losses.

Poor investors see every loss as a failure. But small losses aren't failures. They are victories – victories against big losses. You must avoid big losses at all costs. Few can survive a big loss.

Good investors know this: Losses are part of the game, and small losses don't matter.

As an investor, having an exit strategy is vital to your success. If you stick to your exit strategy, it can serve as a near-foolproof way to methodically cut your losses and let your winners ride.

One of the best exit strategies is to set stop losses. These are set prices or percentages you use to know exactly when to sell.

There are two types of stop losses: hard stops and trailing stops.

Hard stops are based on a set price or percentage below the purchase price. If the stock falls to that amount at any time, you sell.

Let's say you purchase Stock X at $10 and set a 20% hard stop at $8. No matter what the stock price rose to for Stock X, once it fell to $8, you would sell.

Trailing stops are based on a percentage below the purchase price, but they don't stay the same. As the price rises, the trailing stop follows it.

For a trailing stop, let's say you would initially set it at 20% below your purchase price. So for Stock X, you'd start out at $8, the same as a hard stop.

Here's the difference... As Stock X's price rises, the trailing stop also rises. So if the stock rises to $11, the stop would rise to $8.80. If Stock X kept going up to $15, the stop would be $12.

Trailing stops only adjust upward and stay set on the highest price the stock hits. So in this example, if the stock hits $15 and then goes down, you would sell at your trailing stop of $12. But suppose the stock falls to $12 and you sell, and then it shoots up much higher. In that case, you've still made a $2 profit ($12 – $10 purchase price), but you've forfeited any future gains.

Both strategies work well in different situations. So now you might be asking...

How Do I Pick the Right Kind of Stop?

Hard stops work well for income-generating investments. Trailing stops work well for growth investing.

For example, if you purchase a stock that pays huge dividends, you may not care if the share price bounces up and down because you're earning income no matter what. So having a hard stop would keep you in the position despite these moves.

If you're looking for long-term capital growth, you want to protect your capital gains. A trailing stop not only protects your original investment (as the hard stop does)... It also protects your gains.

What price point you choose for your stop depends on the type of company you're investing in and your personal level of tolerance for volatility.

We tend to recommend a wide 25%-35% stop for more volatile positions, like oil and gas stocks. This will allow for the cyclical swings in share price that the commodity industry is known for without kicking you out too early.

Similarly, we tend to recommend a narrow 15%-25% stop for less volatile positions, like well-established companies that dominate their industries. Companies like Johnson & Johnson (JNJ) and McDonald's (MCD) are so large and liquid, their share prices don't tend to move much.

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Never Enter Your Stops

Most brokers give you the option to enter your stops "into the market" using stop-loss orders or trailing-stop orders.

We advise you to never reveal your stop loss to your broker or anyone else.

Entering your stop price into the market might seem easy, but it leaves you vulnerable. Investors or brokers who see your stop might be tempted to move the share price to push you out of the position. So never enter your stops into your brokerage account as part of your order. Track them on your own with sites like Yahoo Finance or TradeStops.

Using strict stop-loss rules to avoid capital losses removes emotion from the trade. When you're wrong, admit it and take your lumps. It's one of the most important rules to successful investing.

Remember, before you invest, know exactly why you're buying the stock. Set yourself up to succeed by knowing ahead of time what your exit strategy is. Stop losses are a great asset for any investor, so start using them to monitor your portfolio today.

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