Two ways to avoid nasty losses in the stock markets

UK Investors have lost tens, if not hundreds of billions over the last couple of weeks.

For some it's been a nightmare. But what most investors won't have realised is that many of the worst losses could easily have been avoided. How?

By setting your stop losses right.

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Stops can be tricky little beggars in falling markets they can virtually assure you big losses. As the markets tumbled last week many investors will have seen their stop loss orders triggered, locking in savage losses just a few hours before the market recovered.

It needn't have been that way. Today I want to look at how to adjust your stops so the market doesn't needlessly knock you out of your hard-earned positions.

I'll point to two simple measures that you can take both of which have helped me to avoid really nasty losses when the market goes volatile.

It's easy to fall foul of a bad market

Stops can be a wonderful thing. You can use stops either to book profits (trailing stops), or to activate a sell order on a losing position. As the market started to slide, they will have taken many investors out of a falling market. Great! See here for a reminder about stop losses and their dangers.

But many stops last week will have been triggered right at the market lows locking in awful losses. And the really galling thing is that they would have been triggered for all the wrong reasons. Let me explain.

Many investors place their stop order when they buy a stock. Maybe they set it at 20% below their open price. That way the stop loss order will protect them in case they've made a mistake.

Humility is a great thing especially for investors. You need to know when to admit a mistake. And you must always be prepared to dump investments if your assumptions were wrong.

But if you bought stocks over the last six months or so with a 20% stop, you may well have found yourself kicked out of your position. And that probably had nothing to do with your stock choices. By using stops, you can easily get knocked out of positions just because the market's having a bad week.

How do you avoid that happening to you?

Two ways to avoid the really nasty losses

First, assess the volatility of the stocks you own. Last week some stocks will have done much worse than others. High beta stocks are the really wild ones. If you've got a stock with a beta of two, you can expect it to fall twice the amount of the wider market.

You can get beta values from websites such as digitallook.com, or advfn.com. They can be a really useful guide to how volatile your stocks are. Generally, the higher the beta of your stock, more generous you should be with your stop loss. (You can read more on beta here)

Secondly, you should also be prepared to adjust your stop orders with the market.

On Friday, I made the argument that the market looks cheap at these levels, and at some point it will surely bounce back. All right, government finances are looking pretty ropey, but many of the big corporations are performing extremely well. Even with the recent mini-bounce, the FTSE 100 is still trading at less than nine times earnings.

But just because markets are cheap, it doesn't mean they won't get cheaper. The market may not put in its lows for a while yet. That's why you may find it useful to adjust any open stop loss orders.

For some types of short-term trading, I love to use automatic stops. I can't possibly keep my head glued to a monitor day and night following the price action in currencies and commodities.

I plug in the figures onto the dealing platform, and I let the computers get on with it. I have a plan, and the system makes sure that I stick to it.

How I manage my stop losses

But when it comes to my general stock portfolio, I prefer to monitor stops manually. I'll keep an eye on what's happening in the markets and with individual stocks. If I've made a mistake, I've got no problem bailing out. But I'm not going to do so before I've assessed exactly what's going on.

And that includes what's happening with the wider market.

During this latest market rout I haven't sold a thing. Several stops would normally have been triggered last week, but I made some adjustments.

I monitor my positions on a spreadsheet as well as details on profits/losses, I also keep my 'trading notes' and stop loss indicators there too. As the market fell, I lowered the stop losses on my positions.

If the market falls another 10% from here, then I'll simply lower my stops by a similar amount. Don't get me wrong. If my stocks fall by more than the market and hit the newly adjusted stop, then I'll look at selling. And to be honest, I don't know where the market is going from here.

But whatever stocks I hold, I want to keep them. I'm not going to hit the trigger and sell just because they're sucked into the market's downdraught.

Stop losses are there to keep you from holding onto stocks long after their sell-by dates. They're not supposed to make you sell your stocks at the bottom of the market!

What do you think? Did you manage your stop losses last week?

This article is taken from the free investment email The Right side. Sign up to The Right Side here.

Important Information

Your capital is at risk when you invest in shares - you can lose some or all of your money, so never risk more than you can afford to lose. Always seek personal advice if you are unsure about the suitability of any investment. Past performance and forecasts are not reliable indicators of future results. Commissions, fees and other charges can reduce returns from investments. Profits from share dealing are a form of income and subject to taxation. Tax treatment depends on individual circumstances and may be subject to change in the future. Please note that there will be no follow up to recommendations in The Right Side.

Managing Editor: Frank Hemsley. The Right Side is issued by MoneyWeek Ltd.

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