While a stop order can limit losses, not staying in the market can deprive a portfolio of lower prices. By Christine Giordano
MARKET SURGES AND DIPS are just par for the course if you're invested in stocks. But when your stocks' prices fall in a bear market, it can feel like you're on a ship in high stormy seas: You don't know when the storm will end, and it's hard to know how to protect yourself. Should you set your stocks to sell if their prices hit a specified low? Or should you ride out the bear market?
The answer depends on your goals, says JJ Kinahan, chief market strategist at TD Ameritrade.
"The key is what was your plan on a trade when you first (got) in to the trade," Kinahan says. "I think that the planning step is often one people miss and those that do not have one are often the same folks that make the decisions that we all refer to as emotional investment decisions."
Let's say you want to buy 600 shares of a stock over time, and you have a plan to buy it for an average of $45 over the next year. If the stock is trading at $50, you'd buy 200 at $50, put in a bid for 200 shares at $45 and 200 at $40, Kinahan says. You'd be "using movement as a friend and (have) both a time frame and price levels in mind. If the stock does not fall to those levels, that is also fine," he says.
Investors should assess their goals at least quarterly.
Stop orders. Those that trade more frequently might use stop orders to sell when a stock hits a certain bottom price.
"These also take some thought and preplanning: If you have a target on the downside of where you want to get out, you should have a target on the upside," Kinahan says. "Make sure that you are not going to make the mistake of taking very small winners and big, big losers. Don't take $1 on the upside if you are willing to lose $3 on the downside. That math will not work out long term."
Russell Robertson, certified financial planner and owner of Alidade Wealth Partners, says not to use stop loss orders to sell.
"Once the stop is triggered, it becomes a market order," he says. "There's no guarantee you'll be able to sell at the price you set the stop at. Use stop limit orders if you just want a standing order to sell."
Risks of stop-losses. Stuyvesant Capital Management's portfolio manager and research analyst Jason Cooper says the firm is currently skeptical about the use of stop-losses given the intense volatility of the markets.
"When the Dow dropped 1,100 points on the open during the flash crash on Aug. 24, 2015, an investor with a stop-loss would have sold into panic, missing out on the market reversal that occurred over the ensuing trading days," Cooper says. "Executing the trade would have resulted in the investor realizing capital gains, which would have increased their tax bill."
To minimize risk, Cooper advises an asset allocation that "favors defensives securities over their cyclical counterparts. We also currently advise against chasing momentum in risky fixed income products such as high-yield bonds, emerging market debt and noninvestment grade municipals."
Opinions vary, but Robertson believes an investor planning to retire in the next 10 years probably can't afford to ride out the next bear market.
"If you're a millennial, you can afford to ride out the bear market, especially in your retirement portfolio," he says. "For anyone thinking they will ride it out, we recommend holding in cash any big expenditures coming up in the next two to three years."
Covered calls. Kirk Du Plessis, founder and head trader of OptionAlpha.com, says investors can survive a bearish market by using a covered call strategy. With covered calls, you sell call options against shares of stock you already own in return for a premium which reduces the cost of ownership in the stock.
"For example, let's say you owned 100 shares of XYZ Company at $100 a share. You could sell one covered call at the $105 strike price for $2 a share for the next 30 days," Du Plessis says. "In this example, you would forfeit any gains above $105, but reduce the cost of ownership down to just $98 a share. This means that the stock could fall up to $2 this month and you would still not lose money."
"The problem with a stop-loss is not when you should get out, but when you should get back," says Ryan McGuinness, who spent eight years in corporate finance for Fortune 500 companies before founding the wealth management firm CTR Financial.
Another question to ask yourself is: If you sell, how will you invest your funds?
"You need to predict where the market is going to go and that's been shown to be nearly impossible," McGuinness says.
On Dec. 29, 2015, the Standard & Poor's 500 index ended at 2,078. Toward the end of January 2016, it had dropped 10 percent. By Feb. 11, 2016, it dropped to 1,829 or about 12 percent.
"If you had your stop-loss order in at 10 percent, you would have saved yourself some small losses," McGuinness says. "But then what? Did you wait for more losses to pile up that never came? The market is up nearly 18 percent since that bottom. If you sold after the drop, you missed out."
McGuinness adds, "What we know for sure is that while over the short term markets drop, over the long term they always go up."
To prove his point, McGuinness cites the worst 30-year period for the S&P 500 from 1927-2015, which generated an annual return of 8 percent.
"It's below the average of 11.1 percent, but still not bad. If you were jumping in and out of the market, you probably missed a lot of those gains. And earning only 8 percent took some really bad luck," he says. "It assumed you invested right before the Great Depression, but even then, if you stuck it out, you did well."
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