Why investors should use stop-losses


Last year global stock markets lost $29 trillion in value -- falling 42%. And although it does not get much media attention, there is something that investors can do when the stock market moves against them. They can set stop losses on their stocks which limit how much money they can lose. Specifically, if an investor buys a stock at, say, $20 a share, he or she can issue a limit order which requires the broker to sell the stock when it declines to a lower price, say, $18. Such a limit order would limit the investor's loss to 10%.

This comes to mind in considering why the average stock in my investment newsletter gained 15% in 2008 when the S&P 500 fell 38.5%. My monthly newsletter analyzes broad economic trends and bores into specific industries. It also picks three stocks each month for subscribers to consider. During the first half of 2008, the energy and commodities stocks mentioned boosted its performance to +29% through the end of June. Then the bottom began to fall out as commodity prices tumbled and the financial services industry collapsed.

Thanks to the 2% stop loss rule -- which automatically sells any stock that falls 2% below the price at which it was mentioned in the newsletter -- the low point for the year was -1% at the end of October. By the end of 2008, only four of the 36 stocks mentioned remained in the portfolio. However, thanks to a surprising boost in one stock mentioned at the end of October and the three stocks picked at the end of November, the average stock was up 15% by the end of 2008. What were the three best performers?

  • URS Corp (NYSE: URS) rose 22% from $33.41 at the end of November to $40.77 by year end. URS -- a design and construction firm, won a $3.3 billion contract in December and may be perceived as well positioned to take advantage of an infrastructure stimulus package expected in early 2009;
  • AAR Corp (NYSE: AIR) rose 15% from $15.99 at the end of October to $18.41. AAR -- which supplies aviation parts -- saw its sales rise 14%, fully-diluted earnings climb 21% and its backlog increase 28% in a December report; and
  • Plexus (NYSE: PLXS) increased 11% from at the end of November $15.21 to $16.95. Plexus develops and manufactures electronics telecommunications, medical, industrial, and computer companies.

Without the 2% stop loss rule and some lucky year end picks, this would have been a bad year for my newsletter. The big lesson here is that investors should consider stop losses -- particularly for individual stocks in their portfolio.

Peter Cohan is president of Peter S. Cohan & Associates. He also teaches management at Babson College and edits The Cohan Letter.

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Last updated: February 10, 2012: 04:11 AM

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