Can You Win by Cutting Your Losses?

When you invest during a bear market, risk will always be on your mind. While you may hope to take advantage of beaten-down share prices to grab stocks that will turn into multibaggers, it's just as important for your overall returns to avoid taking a big loss on any one position, should things not go as you expect.

To prevent small losses from becoming big ones, many traders use stop-loss orders. In a market where many companies, such as Tesoro (NYSE: TSO  ) and AMD (NYSE: AMD  ) , have slowly but surely seen a big portion of their value slip away, a technique that could limit your losses looks appealing. But while using stop-losses does provide some protection against major hits to your stock positions, the strategy also has its weaknesses.

The basics of stop-loss orders
The way stop-losses work is pretty simple. For a given stock, you decide the maximum amount you're willing to lose. You then calculate how low your shares would have to go to create a loss that big. By entering a stop-loss at that level, if the share price ever falls below it, your shares will get sold, thereby preventing any further losses.

Most brokers allow you to enter stop-loss orders for your account. You can choose any price for your stop-loss that you want, as long as it's below the current trading price. If all goes well, and your stocks move upward without ever hitting your stop-loss price, your orders will never execute, and you'll enjoy the full benefit of seeing your shares skyrocket.

You can use stop-loss orders in various ways. Some investors set stop-losses immediately after they buy a stock, then leave them alone. Others use trailing stop-losses, where they raise the trigger price on the stop loss as the stock goes up. For instance, if you bought shares of a stock at $50, you might set an initial stop at $40. Once they rise to $100, though, you could move the stop-loss up to $80, in the hopes of locking in at least a $30 profit.

Nothing's perfect
Unfortunately, stop-loss orders don't always work the way investors want them to. For one thing, share prices sometimes fall dramatically, especially when companies announce bad news while the market's closed. As a result, you may not be able to get the price you wanted if a stock's drop triggers your stop-loss order.

For instance, Google (Nasdaq: GOOG  ) closed around $530 last Thursday, immediately before announcing earnings. You might have decided to set a stop-loss order at $520, hoping to limit your losses in the event of a bad report. However, when the market opened the next morning, Google first traded under $500. As a result, if you used a market order with your stop-loss, you wouldn't have gotten $520 for your shares -- you would have gotten less than $500 instead. The stop-loss wouldn't have limited your losses as much as you wanted.

The long-term dilemma
Although losses from sharp stock plunges can make stop-losses ineffective, these orders have an even bigger shortcoming as well. If you think a stock is an attractive investment over the long run, stop-losses can take you out of your position at exactly the wrong time -- just as they hit bottom and resume their long-term uptrends.

The real question is whether stocks are dropping because of actual fundamental problems with their underlying businesses. While a company like Halliburton (NYSE: HAL  ) might recover from temporary setbacks and turn into a five-bagger, there are also plenty of stocks still seeing huge challenges for their businesses. Getting out early could have saved you thousands:

Stock

Share Price If Sold After 25% Trailing Stop-Loss

Current Share Price If Held

General Motors (NYSE: GM  )

32.40

13.09

Fannie Mae (NYSE: FNM  )

52.93

14.13

Washington Mutual (NYSE: WM  )

35.26

5.48

Source: Yahoo! Finance. Assumes initial buy date of Jan. 1, 2006.

Should you use stop-losses?
Unfortunately, it's hard to know up front whether you're seeing a temporary blip or the beginning of a much larger plunge. In the end, deciding to use stop-losses depends on your risk tolerance. If avoiding the next Bear Stearns is worth occasionally missing out on what later becomes a rocket stock, then stop-losses are worth considering. But if you're willing to risk losing everything on one stock in exchange for huge rewards on others, you'll probably find stop-losses more frustrating than they're worth.

Further Foolish advice:

Google is a Motley Fool Rule Breakers recommendation. Discover how many of our growth stock recommendations have held up unusually well in this bear market. A trial subscription gives you full access free of charge for 30 days.

Fool contributor Dan Caplinger does everything he can to stop losses in their tracks. He doesn't own shares of the companies mentioned in this article. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy makes you a winner.


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