Right now, many investors are panicking…
Within the past six trading days, the S&P 500 has seen declines of 2.1 percent, 4.1 percent and 3.8 percent… and global markets have been similarly volatile. It’s a shock, after an unnaturally long period of low volatility and rising markets.
And as we’ve said, this could just be the beginning.
So what should you do? How can you protect your portfolio in a falling market?
The easiest thing would be to sell everything and walk away. But you’ll likely regret it the next day. And the magic of compounding only works if you’re invested.
Instead, make your investing decisions automatic and emotion-free…
The key to dodging big losses
The key to not suffering big losses – and having enough capital to see another day – is to establish a plan for every investment and follow it. Before you buy a stock, know when you’ll sell it.
No one likes to admit defeat. But in investing, it’s important to have a disciplined approach to selling your bad positions.
For most people, clinging to the hope that a losing trade will turn around is far easier than admitting it didn’t work, selling, and moving on.
In these kinds of markets, it’s easy to tell yourself: “If I just hang on a bit longer, this stock will reverse and go up.” If the market bounces back, you feel like a genius… until it falls again. And in a bear market, the trend is down – so those up days don’t make up for the down days.
Peter Churchouse went from growing up in a tiny town in New Zealand to being a multi-millionaire investor and banker who spends days as he pleases… thanks to an investment he says made him more money than anything else in his life.
Learn more about the secret behind Peter’s success here.
The thing is, it’s against human nature to take losses. Behavioral scientists have established that humans have a hard-wired risk aversion bias. Studies have shown that losses are about twice as painful as gains are pleasurable. So investors have a strong tendency to sell winners quickly, and to hold on to losers… all the way down.
But this is the exact opposite of the old investing adage: Cut your losers short, and let your winners run. Successful investors do what failed investors can’t – they override the risk aversion bias. (For more about why, see this article… remember that if you’re down 50 percent, the share price needs to double just for you to be back up to break even. And so on.)
So how do you create a loss aversion plan for every stock you own?
Have a mental stop-loss before you enter a trade.
Use a trailing stop-loss to minimise damage
The best kind of stop-loss order is a trailing stop-loss. This order “trails” a rising stock by always resting a pre-determined amount (either a percentage or an absolute figure) below the stock’s most recent high (that is, since you’ve owned it).
(One important point: Make sure you don’t put a standing market order in at your trailing stop level. You don’t want to tell your broker when you’re going to sell. Make sure that you make it a mental level – not one that you tell your broker. And then watch it.)
For example, let’s say before you buy a stock for US$10 and put a mental trailing stop loss at 20 percent. That means if the shares fall 20 percent below US$10 (i.e. to US$8), you’ll sell (I calculated that price by taking 10 * (1-0.2)). Of course, twenty percent is a lot… but if you’ve decided that that’s what you’re willing to lose, then establish the stop loss, and monitor.
Let’s say that shares rise to US$12 after you buy. Now, instead of having your stop at US$8, your stop will be 20 percent below the highest price the stock has reached since you owned it – which is US$12. So your stop will be US$9.60 (12*(1-0.2)).
Remember, even if the stock then falls to US$11, your stop will stay at US$9.60 because US$12 is the highest price the stock reached while you owned it. That means that the worst thing that can happen (as long as you monitor the share price) is that you lose 4 percent of your initial investment.
A trailing stop allows you to “let your winners run,” while keeping a stop-loss order at progressively higher levels as stock moves higher. A trailing stop-loss allows you to focus on other things, because your trade management is on “auto-pilot.” It takes the emotions out of investing.
Selling a stock at a loss is disappointing. But it limits your downside and protects your capital so you can invest in other opportunities down the line.
Publisher, Stansberry Churchouse Research