By Peter Mastrantuono
Most investors can articulate a buy discipline-“I buy stocks that are undervalued to the market.” or “I look for stocks with above-average earnings growth.”—but few investors have a sell discipline governing when it’s time to sell. Absent a clear sell discipline investors are more likely to hold onto faltering investments for far longer than they should.
Why is having a sell discipline so important? Consider this basic mathematical truth. An investor who loses 50% on an investment will need a 100% return just to break even. A loss of 25% requires a 33.34% return to recoup losses. This inescapable investment reality makes it imperative that investors enter into any investment with a clear exit plan.
One cornerstone element of a comprehensive sell discipline is the “stop-loss order,” or “stop-limit order”, which are very similar in concept but have one important difference.
The stop-loss order and the stop-limit order are both designed to help investors limit losses to some predetermined level in order to protect against large losses that may occur as a result of highly volatile markets, investor inattention or company-specific news that sends its stock price in swift retreat.
Let’s examine first how a stop-loss order works. You decide to invest in a company whose current stock price is $50 per share. As part of your sell discipline, you are not comfortable with enduring a decline of 20% or more in the stock’s value.
With a stop-loss order you can instruct your broker to sell your position should the stock reach $40 per share (i.e., 20% below your purchase price). If the stock falls to $40 or below, your stop-loss order becomes a market order, in which case your stock will be sold at the next available price. Because market prices are always changing, the actual price you receive may be above or below the trigger price of $40.
The stop-limit order is different in that it does not guarantee execution of a sale. For instance, if the stock price trades at or through the limit price (e.g., $40), it becomes a limit order and will be executed only if the market price is equal to or above your limit price ($40). If the stock price remains below the limit price, your order will remain open until the stock price has moved back to $40 or higher, at which point the order will be executed.
The price you set for a stop-loss (or limit) order should reflect two key considerations: 1) your tolerance for capital loss, and 2) the magnitude of decline that signals to you that it’s time to reconsider your investment thesis with respect to a particular company or the direction of the overall market.
When setting a price for a stop-loss (or limit) order, you want to make sure that you don’t set a price too close to your purchase price (e.g., $49, using our example) since normal market fluctuations may trigger an order to sell prematurely.
Remember, a stop-loss or stop-limit order is only one element of an overall sell discipline. A financial advisor can be invaluable in not only establishing an appropriate trigger price for your stop-loss and stop-limit orders but also in designing a thoughtful sell discipline that can protect and enhance your portfolio’s returns.
Peter Mastrantuono is a contributing writer to http://www.myperfectfinancialadvisor.com, the premier matchmaker between investors and advisors. Peter worked for over 30 years in the wealth management industry, focusing on retirement planning, investing, asset allocation and financial planning.