The volatility the stock market experienced over the fall of 2008 and the raging winter of 2009 had the effect of either chasing fearful souls out of that market, or educating them on how they could better protect themselves. If the recession also incurred a job loss (and thereby, the means to pay for their shares) there was also the toll such volatility took on one’s psyche, besides one’s pocketbook.
Still, as equity markets - both big- and small-cap – collect themselves after a brutal fall and winter, there are methods you can employ to keep your shirt on when prices go south.
The key to remember is that, fundamentally, it is not that difficult to manage money; it’s at times very difficult to manage your emotions, and if those emotions are not kept separate from your investments, you are likely to sell those investments at exactly the wrong time.
To limit losses, you can tell your broker to place a “stop-loss order” on the stock you’ve just bought. Say you can stomach one company’s price descending to a certain level, but not below that.
For example, let's say you bought 10000 shares of Underworld Resources (TSX: V.UW) at 20 cents towards the end of 2008 for a total cost of $2,000. The investment you made in that company would look really good as the stock now hovers around the $1.50 level, giving your shares a value of $15,000. You want to continue holding the stock so you can participate in any future price hikes it may see. However, you also don't want to lose all of the unrealized gains you have built up so far with the stock, in case UW starts dropping considerably. In this case, you would want to set a sell position based on your risk tolerance and sell the shares if it hit that stop loss price. On May 27, the stock hit a high of $1.70 a share and closed at $1.41 that same day. If you were to adjust your stop loss on a daily basis, and felt comfortable with a 20-cent price swing, your stop loss would have been for $1.21. The following day, the stock did take a bit of a drop to $1.30 a share, but ended up closing at $1.59. In this example you would still have been in the stock as the price did not drop below $1.21 and instead rose on the day. But if the stock would have dropped to an intra-day low of $1.20, then your stop loss would have been triggered to protect your investment and give you a sell at around the $1.20 level, depending on the price available at the bid.
Your investment on UW would have earned you $12,000, minus your $2,000 initial investment for a profit of $10,000. In this particular example, though, the price did not reach $1.21 so you would have continued to be in this stock and with the stock currently at over $1.50, your investment continues to grow. If you keep protecting yourself from future price drops, a stop loss will ensure that your investments will continue to grow in value and at the same time protect you from any sudden price drops, which could wipe out gains quite quickly if you are not following the stock every moment of the trading day.
The stop-losses cousin, the “trailing stop order”, also protects you from share price declines and maximizes potential returns at the same time. The trailing stop price is adjusted as the price changes.
Experts say the trailing stop price is such a useful tool, yet many fail to use it, when it could enable them to let profits run while cutting losses at the same time. A trailing stop loss basically eliminates the need to constantly modify the stop loss price as given in the previous example, but unfortunately for penny stock investors, is not available for stocks listed on the TSX-Venture Exchange, Pink Sheets or OTCBB. These investors will have to make do with the manual stop loss.
In cases where one cannot (or chooses not to) employ these techniques, investors may decide to turn more aggressive when stock prices go down, buy additional shares in a company at these lower prices, thus bringing down the average price you pay. For example, holders of stock for JA Solar Holdings Co., Ltd. (NASDAQ: JASO) that bought shares at the beginning of 2009 for $5.00 a share, saw their shares drop to $2.31 a few weeks later, Jan 21 to be specific. If the investor was confident in his investment and felt that the price was undervalued and decided to pick up some more shares, his averaging down would have been successful. Picking up 1,000 shares at $5.00 a share cost him $5,000, then picking up another 1,000 shares at $2.31 cost him another $2,310, for a combined total of $7,310. When dividing that amount over 2,000 shares, the investor successfully averaged down his investment to $3.65 a share. What that means is now JASO only needed to hit $3.65 for the investor to turn a profit instead of the initial $5.00 a share. From this example we see that JASO powered forward in the last few months and is not trading at over $4.50 a share. If the investor would not have averaged down, he would still be in a loss position right now, however if he would have averaged down, he would now be profitable as his $7,310 investment is now worth around $9,000.
Rather than panic, investors that were caught in that situation could have recognized that that descent in price could have presented a bargain for them (especially if they’re well acquainted with the company and have followed its fortunes), and decided to take on more JASO shares while they were that cheap. Such folks would have engaged in what’s called “averaging down”, and their patience would have paid off. However, investors need to take note, that just as easily as a stock goes up, it can go down. Averaging down can work to get you out of mis-timed investments, but could be a recipe for more loss as piling in more money may never return past results, so please use this article as a warning to why stop losses should always be implemented so that situations where averaging down comes to play rarely occur.
“Averaging down” is not unlike what mutual fund investors experience when they practice “dollar-cost averaging”, buying more and cheaper shares every week as unit values go down, with the hope that such values will appreciate as the market improves. However, the site Investopedia.com says, while sometimes averaging down is a good strategy, other times it's better to sell off a beaten down stock rather than to buy more shares.
Sometimes equity investing involves a recognition of the risks involved. One can hit a “home run”; one can lose one’s shirt. There are those two extremes. And just repeating: it’s important that your buying practices are based on sound reasoning rather than frazzled nerves. It’s better to lose a little money, dust yourself off and try again then to sit with a huge loss if something goes wrong with the stock you invested. The stock market is risky, and requires risk tolerance, patience and plenty of education to make informed decisions. That being said, if an investor follows these and other investing strategies, the risks associated with trading are minimized substantially.
In the end, it’s important to remember that last year’s winners among stocks are seldom the big winners this year, that diversification is important, and that especially, penny stocks – however attractive their field of endeavour or prices - are fraught with risk and should be balanced out with other investments, like blue-chip stocks, bonds or short-term money market instruments.