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Avoid Financial Disasters with Trailing Stops

By Chuck LeBeau, SmartStops.net Director of Analytics  (originally published Jan. 2009)

In less than a year six widely held financial stocks (Fannie Mae (FNM)’ Freddie Mac (FRE), Lehman Brothers (LEH),

American International Group (AIG), Washington Mutual (WM) and Bear Stearns (BSC) have cost Buy and Hold investors more than $840 billion dollars.  That’s billions more than the controversial government bailout that has the entire country up in arms.  If we add in the losses in the rest of the market we are talking about recent losses measured in trillions of dollars.  (I’m certain that many of the Lehman and Bear Stearns account executives advised their clients that the best way to invest was to Buy and Hold.)

Think of all the retirement funds and college tuition money that has been needlessly lost in these few months.  It’s a very sad scenario for average investors who are not Wall Street tycoons.  However the saddest part is that the investors who lost all these billions and trillions of dollars could have avoided this disaster by simply using some logical form of trailing exit to protect their investments.

Buy and Hold is not only the riskiest possible strategy it doesn’t qualify to be called a strategy.  Buy and Hold is actually the absence of any intelligent exit strategy and is mostly adopted by default.   Buy and Hold is only recommended by unknowing pundits who are out of touch with the modern market place and are willing to advise their followers that taking unlimited risk and being in the market 100% of the time is a good idea.  Obviously that mistaken advice has proven to be very costly.

Investors should be concerned that there may be even more disaster stocks in the months ahead.  The investing climate has changed forever and Buy and Hold should no longer be the exit of choice for mainstream investors.  In the last few years many well known stocks that were once considered “blue chips” have declined 90% or more.  Volatility in the market is at an all time high and expanding.  Prudent investors must learn to protect their stocks with some intelligent form of exit strategy.  The days of being patient and comfortable with Buy and Hold are long gone.  The risks of Buy and Hold are now much too high and the returns over the last ten years have been less than zero.  Buy and Hold investors have been exposing their capital to unlimited risk for meager or negative returns.

One obvious exit strategy that can prevent catastrophic losses is the use of a trailing exit commonly known as a “stop loss order”.  In the past most investors have been reluctant to use trailing exits because they are afraid that after they exit the stock might recover and go back up.  The obvious solution to that problem is to simply have a plan to reinstate the position when the liquidated stock shows signs of recovery.  Selling a stock doesn’t have to mean that you have given up on its prospects for the future.  Selling is just a temporary measure necessary in today’s markets to protect your capital from the increasing probability of catastrophic losses.

If the stock you sold declines you may very well want to buy it back and you will now have the capital to buy more shares than if you held your original position.  One of the blessings in these highly volatile markets is that transaction costs are so low now that they are virtually inconsequential and measured in fractions of a cent per share.  An extra $10 or $20 in transaction costs is a small price to pay to protect hundreds of thousands of dollars from permanent loss.

Here are three suggestions on how to implement an effective trailing exit strategy

1)       Identify the direction of the current trend.  If the trend is Up you will want to set the trailing exit a safe distance away from prices so that you do not exit while the stock is trending up.  You want to let profits run.  If the trend is Down set the exit closer to prices to cut losses and preserve capital.

2)      Keep an eye on volatility and adjust the exits farther away if volatility increases and then move them closer if volatility decreases.  The exits need to be kept outside of normal up and down price action which changes with volatility.  Volatility is presently at record levels so give the upward trending stocks plenty of room.

3)      Before you exit, make sure you have a plan to reenter the stock if the uptrend resumes.  The trailing exit provides a very valuable yet inexpensive form of loss insurance.  The price of that insurance is that your exit may occasionally get you out at a point where the stock stops going down and turns up.  Rather than miss the uptrend and blame the protective exit for the lost opportunity, simply buy the shares back.  Worst case, you will have paid a small price for protection from a possibly catastrophic loss.  Your exit did its job.

This simple advice would have saved investors trillions of dollars over the last twelve months and I’m confident that it will save investors trillions of dollars in the future.  Buy and Hold is dead.  Most investors are not going to miss it; may it rest in peace.

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