You’d think with the amount of experience I have investing in stocks that I wouldn’t get caught up in the moment. Yet when stocks were coming out of the COVID malaise, I decided to forget everything I knew and invest in an ETF at the top of its price range. I had made a plan to invest equally between two ETFs, but this one was such a “winner” that I threw out the plan and put everything in it.
You know what happened. I invested at $60 per share and the shares immediately started dropping. Here I was with a stock I had mentally invested in, one that I just knew would be a money maker, and it was going all wrong. What could I have done differently to protect myself from my greed?
Stop Orders
I’ve written before about different types of stock orders, one of which was a stop order. As a reminder, a stop order is where you purchase or sell a security once it hits a set price. For instance, if you place a stop order on a purchase, the trade will be executed as soon as the set price is reached.
Note that it’s not purchased at a set price, only implemented when a price is reached. Let’s look at an example. Let’s say you want to buy XYZ for $25 per share. When it hits $25, the stop order turns into a market order, which means your trade will be executed at the available price at that time; it could be above or below $25.
In my greedy example, if I had set a stop order to sell the stock if it went below a certain price, I would have saved money (somewhat) due to my brain lapse. The question, of course, becomes at what price should I set so I’m protected on the downside?
IBD’s 8% Rule
Investor’s Business Daily (IBD) sets their initial sale rule at 8%, meaning that if you buy a stock and it initially tanks, sell it if it drops by 8% or more. They base this on more than 130 years of market research and note that while a stock may fall it usually only falls 8% or more when “something is wrong with your chosen entry point.” While it’s tempting to wait on the stock to see if it recovers, what happens next is anyone’s guess. After seeing an initial drop of 8% it’s time to save capital and rethink your assessment of the stock.
One thing to keep in mind: if your stock drops 8% you need a return of 8.7% to recoup your losses. If your stock drops 25%, you need a return of 33% just to get back to your starting point. The longer you’re prone to inaction with a dropping stock, the larger the return needed. A stop order placed when you purchase your shares can help take this paralysis away.
Note: you should place your stop order as a “good ‘til canceled” order. This will ensure that the order stays in effect for the limits of your particular brokerage (many keep GTC orders in place for 60 or 90 days).
Make your own rule
Remember that IBD states that 8% is the maximum you should allow your stock to drop initially. They go on to note that you may want to limit your losses to a 3% to 5% range depending on market volatility and your personal circumstances. If you think 8% is too risky for your portfolio, determine a maximum you’re comfortable with. If you find it’s restricting (and you’re selling just as stocks are gathering their second wind), consider increasing the maximum on subsequent trades.
Hopefully you don’t find yourself watching a recently purchased stock test new lows. However, by taking out a little insurance in the form of a stop order, you can limit your losses and know that you won’t be stricken with the inability to sell your stock as it’s falling.