Dale Carnegie was one of the first gurus for self-help, writing multiple best-selling books designed to help people live their best lives. In his iconic book How to Stop Worrying and Start Living, he included advice he received from individuals from all walks of life. One of the chapters quotes a Wall Street stockbroker, who explains how he limited the amount of losses that he was willing to absorb by putting a “stop-loss” on stock trades.
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This principle can be applied to all sorts of financial transactions. Putting a stop-loss order on your finances can help you limit the downside of your financial decisions, by selling off your position before prices drop further.
What is a Stop-Loss Order?
A stop-loss order is an instruction to sell a security if it drops below a certain, pre-defined level. There are two main types of stop-loss orders.
(1) Fixed stop-loss order: In this case, an investor will instruct their broker to sell off a stock if it drops below a certain, pre-defined price point. For instance, say Sam purchases ABC Stock at $50. To limit his losses, he instructs his broker to sell his position if the price reaches $45. Through this action, he has limited his downside to losses of $5 a share.
It is important to emphasize that the selling will be performed at the prevailing market price. In other words, if the price drops from $46 to $44 dollars in one movement, Sam’s broker will execute the trade at $44, and not the pre-defined $45 price.
(2) Trailing stop-loss order: This is a way to lock-in profits, assuming that the equity has risen, while limiting the potential for losses. Using the previous example, Sam purchases the ABC Stock at $50 and instructs his broker to institute a trailing stop-loss of 10%. If the stock drops to $45 or 10%, this will trigger a sell order. However, if ABC Stock rises to $60, this will cause the stop-loss threshold to follow in the “trail” of the rising price. In this case, the new floor will be $54, which represents a fall of 10% or $6 from its high-point after the initial purchase.
However, and as with the first example, the selling of this stock will also be executed at the prevailing market price and not necessarily at the exact price or percentage specified.
What Are the Benefits and Disadvantages of a Stop-Loss Order?
The benefit of a stop-loss order is that it protects your downside losses in the stock market, by limiting the amount that your investments can drop before you sell them. It is a risk mitigation strategy that numerous firms, brokers, and individual investors employ.
This can be an especially useful tool for those investors who do not have the capacity to constantly monitor their portfolio. In this case, they will have the luxury of knowing that their portfolios are protected from catastrophic losses without the need to be actively following their investments.
On the other hand, there are some drawbacks for employing this strategy.
For starters, the ups-and-downs of the stock market push investments in both directions. By automatically selling off a stock when it hits a certain level, investors give up on future gains if the security rebounds. Like any risk mitigation strategy, the more conservative the approach, the smaller the potential rewards.
Another disadvantage is that the stop-loss order does not guarantee the sell price. As explained above, the stock will be sold at the prevailing market price. If the drop in value is precipitous and blasts through the pre-determined floor, the selling price will be less than the amount the seller initially indicated.
Apply Stop-Loss Orders Throughout Your Portfolio
For many investors–including those who are famously successful–preventing dramatic losses is as important as huge wins. In other words, limiting the downside of investments can be even more crucial than being correct most of the time.
Investing often relies upon emotional decisions, and it can be difficult to admit when an investment is not panning out as expected. The stop-loss principle can apply to any type of investment, be it an equity or other asset.
By defining the maximum amount of volatility you are willing to absorb before it happens, you can remove emotion from the equation and sell off your positions without needing to agonize in real time over whether the timing is right. When a price point or percentage is reached, you will know that it is time to sell your investment and move on to greener pastures.
Conclusion: Limiting Your Losses
The goal of any investment is to earn value, though, of course, there are no guarantees. Markets go up, and markets go down. Some investments will be wildly successful, while others will flounder and lose money.
By defining a floor for your losses–either through a fixed price point or via a percentage–you have removed one less worry from your life. And that was really the guiding purpose of Dale Carnegie’s seminal book, which he wrote almost a century ago.
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