Market Crashes

Sell Stop: Creating A Floor For Losses During Crashes

Crashes are the Achilles heel of the buy-and-hold philosophy.

When investors buy securities and decide to hold those securities regardless of the market's behavior, they shackle themselves to crashes and subject themselves to potential losses that could take years to reverse.

They also forfeit their ability to follow one of the guiding principles of investing: buy low, sell high. Investors can't sell high if they only buy and never sell, or if they’re 100% invested all of the time.

When they implement a sell-stop strategy based on their threshold for loss, however, investors can theoretically contain losses and steer their money to safety before a crash arrives. Of course, it is important to keep in mind that there are also times when the market doesn’t allow one to get out at their intended price - in other words, it drops immediately based upon an unfortunate event. That said, it is still important to implement a sell-stop strategy in order to practice risk management.

The Philosophy: Threshold for Loss

Investors should determine how much they are willing to lose once trouble arrives. Investors who analyze moving averages should understand that when the market and the short-term (50-day) moving average dip below the long-term (200-day) moving average, a decline is at hand.

Called the "death cross" by the media, this indicator could signal a mild correction, like the one that sent oil from $88 to $82 at the end of 2013. It could also signal a major crash, like the one that came a year later and sent oil to 13-year lows.

By determining their threshold for loss, investors can potentially exit from a declining investment before irreversible losses mount.

The Discipline: Threshold-Based Selling

Threshold for loss is an excellent philosophy, but even the soundest philosophies are worthless if they aren't backed by a selling discipline. The discipline that can make the threshold-for-loss philosophy work is threshold-based selling.

By placing a sell stop-loss order, investors create a floor that acts as a potential bottom for losses. If an investor buys a security at $100 and decides that the threshold for loss is 10 percent, a dip to $90 triggers an automatic selloff . This may prevent catastrophic losses should the correction turn into a crash.

Thresholds must be based on sell signals and historical correction norms for the security one is investing in, not gut feelings or instincts—and certainly not on industry standards. Investor's Business Daily, for example, advises setting-loss thresholds at between 7 percent and 10 percent—a recommendation that does not consider variables like industry norms. Biotech investors, for example, must tolerate far more temporary loss than technology investors, who typically tolerate more loss than utility investors.

A flat threshold of 7-10 percent is not nuanced enough for all investors in all sectors.

When a death cross appears, a correction has already been triggered. Investors with a loss-threshold philosophy create a bottom by placing at the time of purchase, a (sell) stop-loss order.

The Tactic: Truncate the Tail™

Just as philosophies must include selling disciplines, disciplines must employ tactics in order to be successful. The tactic that shields threshold-for-loss investors from the market's steepest losses is to Truncate the Tail™.

The best returns and the worst losses are the tails of an investment. By attempting to eliminate the lowest valleys, by removing—or truncating—the tail, when possible, investors can mitigate huge losses and long recoveries.

As losses increase, so does the amount of growth needed to recover—but it doesn't grow proportionally. It grows exponentially. It takes 11 percent growth to recover from a 10 percent loss. When losses reach 20 percent, 25 percent growth is needed. A loss of 50 percent requires subsequent growth of 100 percent in order to recover. Negative 80% requires a 400% recovery. The depression era loss of 89% over 4 grueling years took 809% to recover.

By truncating the tail, threshold-based investors mitigate losses and might capture profits that buy-and-hold investors have to put toward exponential recovery. Truncating the tail avoids extremes and keeps investors in the much-less-risky middle. Investors can only avoid extreme loss through threshold-based selling—a strategy that by definition cannot benefit buy-and-hold investors.

Article tracking number 1-472630

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