IFB03: Doesn’t a Stop Loss Contradict Buy and Hold?

Listener Q&A, Podcast Show Notes

When you are looking for advice on how to buy stocks, you will find thousands of articles on the internet. All of them touting the various ways to buy stocks to make money. But what about selling a stock? Crickets. There is not much out there to tell you when to sell. Having an exit strategy when you sell is almost as important as your buy strategy. This is where having a stop loss is so vital to your success. What is a stop loss? It is a set point that you establish as your base point for selling a stock if it starts to fall. The best advice I have seen is setting the stop loss at 25%. Setting the stop loss point here helps eliminate some of the guesswork. And it avoids any impulse sells in a case of sudden movement down.

In today’s session, we will discuss the stop loss and much more.

Setting Trailing Stops

Yahoo Finance for Stop-Loss alerts

Portfolio maintenance

Selling stocks to limit your portfolio to 25 stocks or less

Best strategy to buy stocks, dollar amount or share amount

Dividend reinvestment program or DRIPs explained

Lump sum investing or dollar-cost averaging

Investing outside the US

How do you set a trailing stop? Do you do it with the brokerage or on your own?

Andrew: There are lots of different trades that a broker will offer. A very common one that you might have seen was the stop-limit. What that is basically, you put in whatever you want the price to stop-limit to trade into. And once the stock hits, and in some cases, it doesn’t even need to hit it exactly. The broker will prioritize all their different trade orders. And when it gets close to that price it will execute that trade for you.

When I refer to the trailing-stop in my eletter it’s something I actually don’t recommend inputting to the broker.

For several reasons because the broker will choose buys and sells. You will see this all the time with your broker. Say for example you put in a buy order for $45. And when you look at the actual trade a day later it won’t match the $45 exactly. It will depend on how many shares you buy, who is on the other side of the trade.

There are a lot of things that go into making a trade that we don’t know see because everything is basically on the computer now. But there is always a buyer or a seller that is on the opposite side of your trade. So your broker isn’t always able to make that a one for one exchange. So what they will do with a stop limit. And how that can be problematic if you are putting that into your brokerage account is that they may execute a trade that is not at the price you wanted.

Another thing too is things like flash crashes can activate those prematurely.

I like to recommend putting a trailing-stop in at end of day prices. Because we have seen in 2010 where there was a computer glitch that had to do with the high-frequency trading algorithms. And they caused the stock market to crash at a very accelerated rate in a very short period of time. So if you have stops into the broker they are going to execute those and that’s not what we are trying to do.

The approach I try to preach is a long-term approach. When the media likes to demonize high-frequency trading. And make you feel like the stock market is rigged against you. But, really the people that don’t get affected by those are the people that hold for the long-term.

So we are going to try to hold for the long-term. And put a trailing stop on it. And the way that I do it is to put an alert on Yahoo finance to alert me when the price has fallen to the stop-loss limit. You can track it any way that you want. But I prefer not to check it every single day.

There are many different tools you can use to tell when the stock crosses over the stop-loss point. And once the stock price closes at the end of the day below that point. You can execute the sell then and there.

Should I expect my brokerage to alert me when a stop-loss has been passed?

Dave: No, unfortunately, they won’t. The way it works if you do it through your brokerage account. It will automatically trigger without telling you or notifying you. They will not tell you that the stock price has fallen below your stop-loss limit.

If you set it through the brokerage and it hits that point, it will automatically trigger the trade. Without any notification. It is basically on you to be aware that this is going to happen to your account.

That’s why Andrew and I are both much bigger fans of doing it manually. And not putting it in with the brokerage. This gives you the flexibility to make the decision on your own.

If you put it in the brokerage account the computer is going to see that number and trigger the sale.

This is why we try to avoid doing it with the brokerage account.

Andrew: With my eletter, I am giving new stock buys every month. And with that, I am also doing portfolio maintenance. So you will see with each issue if a stock does cross that stop-loss limit then you can execute your trade then. If life happens and you happen to miss that notification you will see the sell information in the eletter. So you can see if Andrew has put a sell order into that issue. So if you miss it you can sell at that time. Hopefully, it wouldn’t have fallen much longer than that.

Stocks that really get pummelled in the bear market tends to happen over a period of several months. And not in the course of a few weeks. Of course, there are always exceptions to the rule.

I always try to recommend that you track the trailing-stop yourself and if you miss it. Then the stock picks in my eletter can help you catch it. That is part of the service that I offer in my eletter.

Recently in your eletter, you suggested that you sell some of your picks, that doesn’t sound like a long-term approach, could you explain?

Andrew: Yes, most definitely. You are referring to my January issue where we had four sells that I took off of the market.

So, what happens within the eletter’s life is each month I am adding a new stock to the portfolio. So, over time that portfolio builds up and once you reach a point where you have too many stocks in the portfolio.

Then it reaches a point where you want to pull some of those back. Once you reach anything past 25 stocks the point of diversification. And adding more stocks past that doesn’t give you any more additional benefit. If Anything it brings your returns more toward the average.

So, the eletter has been going on for about two and half years. And in that time we have really accumulated a lot of positions. So the big goal of that making those sells was to bring some of those positions down.

It ended up being fifteen or sixteen still open after the sells and there is still a lot of diversification in there. But these were stocks that were if they were a bigger portion of someone else’s portfolio I could have seen them being held on to. But in our position I saw them declining a little bit and because I have this cushion. And I am trying to get a little less diversified anyways. That is why we picked up those profits really quickly.

So, we sold a stock for about a 62% gain, and one was 55%, another was about 50%, and the last one was 20%. So it made sense and those companies, not to say that they were trending poorly to say that the stock could be an issue.

From a business perspective, talking about earnings, talking about asset growth, net worth growth. They didn’t grow as optimally as some of the other positions. So I went ahead and took those profits.

The dividend fortress section of the eletter is really where the very long-term approach lies. So, ultimately the whole goal is to try to build a lot of positions with a small amount of capital. And being able to accumulate those and once they are accumulated. Putting those into the dividend fortress and hopefully, leaving those for decades. Barring any sort of catastrophe in the business. Such as negative earnings or really high debt levels.

Dave: As a long-term value investor I have a hard time selling any of my positions. I do look at my portfolio every quarter when the earnings are released. To see what is going on with all of the companies.

Andrew splits his portfolio up into two different groups. And that is something that I don’t do. I am little older so I am more looking at long-haul. I look at buying something and sitting on it until I retire or beyond that.

I am looking at investing for my retirement as well as my daughter’s retirement. I have a little girl and I am looking to try to get her set up and going when she is old enough.

The companies that I am buying are more of the “I am going to hold these for a long time” camp. So, I don’t always look for the same kinds of things that Andrew is looking for.

I applaud what he is doing, it is a great way to make some money. And to look at other companies to buy to continue making money while he looks for other companies to buy.

The thing that I will do is look every quarter at the earnings that are coming out. I will read those to keep up with the companies and to see what is going on with them.

And if I see something that is troubling or a red mark. I won’t necessarily run right out and sell it right away. But it will put it on my radar as something I will want to pay attention too. I will start to look at many different factors and if they start to add up to a bunch of negative factors. If this creates a negative vibe for me then I will definitely start looking at selling the company at that time.

It is also a good way to mitigate the costs of trading the company.

When you read on the internet about buying stocks. You can find probably five million articles, websites, eletters, and books about buying stocks. But when you talk about selling stocks there is almost nothing out there.

Having an exit strategy is almost as important as when you buy the company. And the trailing stop is an amazing way to help mitigate any losses. As the company may stumble, or the economy may stumble. And it’s a way to ride your winners until they aren’t going to ride anymore. It’s also a way to help mitigate any losses that might happen.

Andrew mentioned a few moments ago about the time length of a stock falling that quickly. To have a stock fall 25% in a day is very, very rare. It doesn’t happen very often. It is going to be a gradual decline unless something tragic happens like Warren Buffett passes away and everyone losing complete faith in Berkshire Hathaway. It is not something you need to lose sleep about. The trailing stop can help lessen that pain.

Having these tools in place is a great idea and having an exit strategy is a great idea too.

Should I buy a dollar amount of shares or a specific number of shares when I do place an order?

Andrew: The broker that use, Tradeking only allows me to trade in full shares. Another strategy I like to use is the dividend reinvestment program. And if any investor isn’t out there using it, it is something that you’ll either be able to toggle it on the online broker website. Or you will actually have to call the broker and ask them to establish that program for you.

What it will do is automatically buy shares of the company when you receive the dividend. When you buy full shares and have the dividend reinvestment program or DRIP. That will help you accumulate partial shares and you will get the decimal point or partial shares. And when you go to sell your shares it will sell the whole shares. And the partial shares you will receive in cash.

If on the buy side when you try to buy, most brokers will not allow you to buy partial shares, only whole shares. I can’t speak to other brokers, but TradeKing will only allow you to buy in whole shares.

In my opinion, it’s a good idea to have a set strategy when buying stocks. It is not a good idea to say, well I have an extra $1000 today. Let’s buy some stocks and then six months goes by and now I have an extra $5000. And let’s buy some more stocks.

With my eletter, we are trying to put $150 in the market every month, because that is what we can spend. I am putting this in my personal portfolio and tracking that to see what kinds of returns I can make over the long term.

By keeping the numbers so small is to show that any average investor out there can find room in their budgets to really consistently put money into the market. So instead of trying to jump around and do it here and there.

When there is not set strategy there tends to be a situation where it doesn’t happen. Kind of like going to the gym, if you always wait until you inspired and it never really seems to come around. You have to set that disciplined system to have some long-term consistency.

Even if it’s a small amount, having that consistent amount that you are going to invest every single month.

Number one it keeps your investments growing over time. And number two, it prevents you from buying at the worst points. So accumulating positions over time and not having to really feel the big negatives of stock market crashes and bear markets.

What to do with a lump sum of money to invest?

Andrew: I will tell you about a personal situation I am in to relate how I would go about handling this question.

I have an old 401k that I have rolled over into an IRA. I did this a few months ago and I have a big lump sum of cash and I want to put it into the market.

It would be really nice to put it in right away. But, number one I want to stay diversified. And because it is a large sum for me personally I don’t want my returns to be based on when I am entering the market.

So, it very well could happen if I put everything I have in today and then we see a bear market for the next two or three years. That could really hurt my returns. At the same time, we don’t know what the future holds.

I could be waiting and the market could have really risen. And I would have missed out.

So I am kind of taking the middle ground and averaging it out over the next ten months. I am averaging in different positions, different stocks. And by and large by doing it over a time period like that I am getting diversification. Essentially on the timing. It’s not going to be perfect because bear and bull markets cycle over very many years.

You can talk about a bull market that can cycle for seven to ten years. We’ve seen twenty-year bull markets before. You can see bear markets that last from six months to eighteen months. You’ve seen two years or longer bear markets.

There is no way to know. Other people might feel differently. Might have different points of view. Online you will people just constantly arguing about lump sum investing or dollar-cost averaging.

I like to dollar-cost average for those reasons.

Dave: Recently I have read lots of studies about this particular issue. And my viewpoint is if you take that money and look at investing it once a month for twelve months. That will give you enough diversification and

consistency of the price point you are going to be paying. This can help you even out the ebbs and flows of the stock market.

If you put it all in one lump sum like Andrew was saying. There is a chance that the market could continue to skyrocket. It also could tank in six months.

If you put it in one lump sum you are timing your price now and you have no control over what happens in the future. Not that you have that much control in the first place.

But if you use the dollar-cost averaging system you have a little more control on when you make your investments. So, therefore, you have a little more control of averaging out the price that you pay.

Let’s say that you buy Apple, for example. Today the earnings were released and the price was up 6%. A week from now it could drop again. And two weeks another drop. And finally three weeks from now it could bounce back up to where we are today. If you dollar-cost average over that time period you would smooth out the price fluctuations.

If you dollar-cost average those funds over the course of twelve months. You are going to do two things. You are going to even out the price that you pay over that time. Second, you are going to get the money in the market so it can do its thing.

Studies have shown that lump sum investing can have better returns over time 70% of the time. That still leaves 30% for a possible failure. To me, that is too great of a risk and I would rather use dollar-cost averaging to help me sleep at night. After all, I am Irish and you know the luck of the Irish.

Would you have any suggestions on investments outside of the US? For you Canadian readers would you suggest anything from the TSX?

Andrew: There are two reasons why I don’t invest outside of the US. Number one is the tax implications. At least here in the states, you get double taxed. If I sell a stock from, let’s say the TSX. I would get taxed by both the Canadian government and here in the States.

So that alone takes away sort of benefits.

I also just as a generality try to invest in US stocks. This is where the majority of the wealth in equities is. Also, the regulations of the SEC helps make it little harder for some of the financial shenanigans to take place here as well.