Stop Loss Orders Protect Your Capital in the Long Run

I have been reading several forums on stop loss orders and the problems people have with them. Many people abandon stop loss orders in a Bear market after getting kicked out of their stock positions and taking some losses.

Stop Loss orders are easy to understand. One of the rules of investing is don’t invest in anything you do not understand. Another rule is only use strategies to protect your nest egg that you understand. Stop Losses meet that requirement for most people.

If you had purchased stocks at the March lows then you would have had a good run up on the stocks you purchased. It is likely that most of your stops placed at maybe 8% below the stock price are still intact.

With the markets going up 20-30% since March if you timed your entry right you have a profit cushion of 20% or more maybe. So if any stock loses 8% you walk away with a profit from that stock of maybe 12%.

Unless you have a problem giving back some profits this is something you will most likely be able to handle since you did not lose any of your capital.

The problem arises when you don’t time your entry well and the market goes sideways and then down maybe 10% -20%. This is very hard to do at the best of times.

In this case some of your stocks will get stop loss triggers and exit the market for you. You will have a loss on those stocks of around 8% and that will probably be a capital loss too. That hurts.

It is this pain that causes many people to abandon using stop losses. But….

That is exactly the wrong thing to do.

In a normal market if it ever returns, as you find stocks to invest in you should apply an initial stop loss order. Then as the stock moves up you should move your stop up with it. This locks in some of the profits and should allow the stock price to move down a little without hitting your stop.

However you may find that after investing in several stocks some of them fail almost immediately as their stop losses are triggered. That’s the nature of investing. For example if you invested in 10 stocks and 4 get hit you take losses on those 4 and the other 6 hopefully start to accumulate some profits. You then purchase 4 more stocks.

At this point you have realised your losses but have no paper or realised profits to offset those losses. You actually don’t want realised profits right now anyway, you want your profits to run. The stocks you still have may be showing a paper profit but until you sell them this profit is not realised.

Depending on the speed of any bull market it might take some time for profits to accumulate. Along the way more stocks might get hit and need replacing. Each time if those stocks are not in profit above your initial stop loss you will realise yet another loss. This is more pain and many people can’t take it, especially if the stocks held are only still showing only a small paper profit.

As realised losses mount, paper profits on those stocks still held may be increasing but the psychological affect of the losses sometimes forces people to abandon their stops on all their stocks.

That’s just when the perversity of the market is at its best. It decides it’s time to become bearish and drops 20 percent taking out all your stock positions. Some of those stocks will show a small profit but most will show a loss.

At this point all your stocks are down 20%. With no stop losses your stocks will be down 20% from their highs. Many may be below your purchase price. They will be showing a paper loss.

If you had kept your stops in place it is likely all stocks stop losses would be triggered and many stocks would realise a loss. But that loss would be limited to around 8% of your capital.

The point is if you abandon the stops you may still have the stocks but you may need them to recover 20% before showing any profits.

On the other hand if you kept your stop losses in place and they triggered, you would have lost less than 8% of your capital and can buy more stocks to enter the market again in the future. You still have 92% of your capital in your bank account.

Or you can sit on the sidelines and wait for more favourable conditions picking up interest on the capital, and sleeping better at night too.

Over the long term this is how it works. You buy a stock and apply a stop loss. Sometimes the market turns and takes it out at a loss. You buy another stock and its price keeps going up and you move your stop up with the price. It accumulates profits.

This is called cutting your losses and letting your profits run.

Initially some stocks get hit and you take loses on those stocks. This can be very unnerving as all you see is mounting losses.

This is the point of stop loss abandonment as you despair over the mounting losses. Instead of saying to yourself you are protecting your capital, you concentrate on the losses.

At some point in a bull market however you will see the accumulated realised losses diminish as stocks with significant profits get hit or you take profits. Either way if your profits are larger than your losses over the long run you will see your realised profits accumulate.

If you had done this in 2003/4/5/6 then by 2007/8 you would have accumulated significant profits. With stops in place in November 2008 even if they all got hit, it is likely those stocks would have realised significant profits.

As this bear got meaner all your stops would have triggered. You would have lost some profits but you would still have much of the realised profits sitting in your bank account along with your capital.

You need to understand the significance of getting into the long run to realise the importance of stop losses and how they can protect your capital and build profits over the long run.

So when you talk to your financial planner about implementing a stop loss strategy you will not be easily dissuaded from protecting your nest egg.

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