How to Avoid Disaster in Your Portfolio
Last year, I read a book on how to survive disasters. In addition to keeping a cool head, which the author admits is easier said than done, one of the most important factors leading to survival was the simple act of knowing where the exits are – on a plane, in a hotel, etc.
Even though I’m guilty of reading my book or watching Netflix on my tablet while the flight attendant teaches passengers how to fasten their seatbelts or put on an oxygen mask, I do look around to make sure I know where the exits are. And when I check into my room at a hotel, I do the same – especially because I have a friend who survived a hotel fire for that exact reason.
I do the same with my stock investments. I don’t start considering when I’m going to sell when the spit hits the fan and when my emotions may be running hot. As soon as my buy is completed, I note the conditions in which I will sell.
For some stocks, particularly short-term trades, I use technical analysis. I look at where support and resistance are (price levels where a stock has traditionally had a difficult time breaking below or above).
For example, here is a chart of Best Buy Co. (NYSE: BBY).
You can see that since June, every time the stock fell near $106, it rebounded. That is called support.
If it broke below $106, that would be a significant change and I’d expect the stock to go lower. So if I were in this stock now for a short-term trade, my plan would be to sell if the stock traded down to about $103, which is 3% below the support level and represents a meaningful break of that support.
Another strategy is to use a trailing stop.
A stop is an order you set with your broker to automatically sell your stock if it hits a certain price level. You should place the stop order right after you’ve bought the stock. That way, your sell order is placed when you are rational and unemotional. If the stop is hit, you’re out and you don’t have to justify why you should stay in.
We use a trailing stop on many positions at The Oxford Club (Wealthy Retirement‘s publisher). And depending on the strategy, we may raise the stop as the stock climbs in order to protect profits.
Emotions are a trader’s and investor’s worst enemy, and stop orders eliminate emotion from the decision to sell.
If you’re invested in a stock for purely fundamental reasons – meaning you love a company’s business – then you should have parameters in mind for why you should sell if the business changes.
For example, you may buy a stock for dividend growth. That growth may be supported by cash flow that has been increasing 10% per year. You may decide that if cash flow growth is flat or negative for two years in a row, you’re done with the stock.
In that event, you’d keep a close eye on the company’s earnings report and, if cash flow went in the wrong direction, you’d sell and move on to a better opportunity.
The important thing is to have your sell decision in place at the time you buy the stock so you are not paralyzed with fear if the stock tumbles.
It’s easy to come up with an excuse for why you should hold on even as the stock is dropping. But if you’ve made a rational decision weeks, months or even years earlier on when to sell, you’re more likely to survive the disaster.