Your Number One Concern in the Stock Market

“Calling the Trend” Column, by George Leong, B.Comm.

In the last visit, I talked about the need for patience and capital preservation when there is uncertainty in the investment climate, much like what we are seeing now. If you chase stocks higher, you could leave yourself vulnerable to a major downside move should the economy falter. These are important points that should be reviewed periodically, so you know where you are.

The reality is that the equity market’s sole purpose is to be a platform for the coming together of entrepreneurs and investment capital. All participants in the equity markets are taking a risk. The one common attribute of all the market’s players is that they are all taking a risk, with the goal of generating some expected returns.

The key is that, no matter how promising a stock market opportunity is, if you take the view that managing risk in your portfolio is the number one goal, you will do well in the long run.

Even the most sophisticated and experienced investors lose — big-time — in the stock market. Not only can losing be considered an element of the stock-picking process, but it also really represents the cost of doing business. No one can predict the future and no one can predict future stock prices. Risk should be your number one concern in the stock market.

Selling a losing stock position can be a very difficult thing to do. But, if one of your holdings drops 30% in value, remember that the ongoing risk to your overall financial position remains the same. Even the investment risk inherent in that same losing position remains the same, it could very well go down even further! This is why the management of risk is more important than potential returns. You cannot manage expected returns, but you can manage the amount of risk in your portfolio.

Using stop-loss limits when investing is an outstanding risk management strategy that always pays off in the long term.

When you take on a position in a stock, you should immediately make note of a stop-loss limit from your entry price, say 20%. You don’t have to do this with your broker; you can easily make a note of it yourself.

A 20% stop-loss limit means that if the stock moves 20% lower in price from your original entry price, you cash out with a loss. By taking this loss, you preserve the rest of your capital to stay in the game. The idea is that your winning stock market positions will pay for your losing ones. This is why you always want to own a basket of stocks, not just bet the farm on one stock.

If you have $5,000 to speculate in small-cap stocks, put $1,000 into five companies and see what happens. Use a stop-loss limit on all five positions. Very likely, some will go down in price and some will go up. The goal is to cut your losing positions and ride your winning positions. It’s a simple strategy that works over the long term.

Now, you don’t just want to employ a stop-loss limit when you take on a new position; you want to have an informal stop limit if your stock goes into profit territory. There is nothing worse than going through the time and effort of finding a great trade, taking the risk, making money, then giving up all the gains because you didn’t take any profits.

So, the best thing you can do is maintain a moving stop limit when the stock trades above your entry price. If a stock goes up 30%, consider maintaining a 10% moving stop limit from the stock’s most recent high. This way, you can consider taking some profits if the stock pulls back.

Remember, absolutely anything can happen to a stock. There could be a war, a strike, a stock market crash — anything. So, you have to take steps to protect yourself.