5-03 Never lose more than 10%
Rule #3 – Never, ever, ever lose more than 10% on any single trade.
We have talked about both stop and limit orders last chapter and using both to build your returns. But as an investor, always remember your #1 goal is capital preservation. Capital preservation is the concept that you do not want to lose the money you put into the market. In other words, your goal is about growing your wealth, not taking a gamble.
Investing Is Not Gambling
Non-investors often compare the stock market to gambling, where every trade is a “roll of the dice” to make or lose money. But that is not the case – investing in a company should be based on research or intuition. And if a stock’s price starts falling, it is usually because something happened with this business that tangibly caused it. If a stock’s price starts to fall and you are not really sure why, it means you probably should sell it until you can figure out what is going on.
Things like a bad earnings report, a new competitor beating them on price, or a completely flopped marketing campaign can cause a stock’s price to suddenly crash 10% in a day. A loss of investor sentiment over a long period of time can make the stock’s price fall 10% slowly over a year – this is much harder to notice, but even more dangerous to your portfolio. Stock prices go up and down every day, but a 10% loss over the course of your investment means something went seriously wrong – and it is time to sell off and re-evaluate what is going on. It does not mean it is time to “Double Down” and wait for the price to rebound – this is how you double your losses!
Use Your Stop Orders
Stop orders, particularly trailing stop orders, should be set as soon as you buy every stock. Different advisors recommend somewhere between 8% and 10% of the stock’s price should be the maximum loss you take before automatically selling it off, and not looking back.
Take some time right now – go back to the virtual portfolio you have already set up and set stop orders on every stock you are holding. This way you never have to worry about a sudden swing knocking out your entire portfolio.
Remember – investing is a business, and your stocks are not your pets or friends. It can always “get worse”, so do not assume that you’ve already taken the loss, so may as well keep holding and hope it rebounds.
Placing a stop loss order or a trailing stop at 8 to 10% below your purchase price is a routine you must practice religiously. William O’Neill, the father of technical analysis and the founder of Investor’s Business Daily recommends the 8% point, but others say 10%. Yes, you will get burned at times. If the stock falls 10%, you get stopped out, and the stock may recover. But more often then not, a stock that falls 10% will continue to decline even further. Sure, it’s OK to buy the stock back later at the cheaper price, but don’t buy it on the way down, wait until it has bottomed, formed a base pattern on the chart, and then shows signs of life again.