Stop Loss

In this guide we have talked about ways in which investors identify attractive stocks.

But it also pays to think about protecting yourself if the market turns against you.

One way to do this is not to put all your eggs in one basket by holding a diversified portfolio of different types of stocks in different sectors. Chances are not all of these stocks will fall at the same time and if some fall others will rise.

Another way of mitigating the risk is by using a stop loss system.

For each stock you hold you set a pre-determined price, and if the share price drops a certain percentage below that figure, then you sell the shares.

In effect you cut and run before the losses get any greater. Stop loss can be an important trading discipline to ensure damange limitation ie you only lose what you can afford to. But it depends on you being emotionally detached from your portfolio and avoiding the temptation to hold on to see if the share price will bounce back.

The benchmark price you use is likely to change with time. For example if the value of your investment rises, you can raise the stop loss limit. One popular way of doing this is to set the stop loss at the point where you will break-even.

And if you investment does really well you can graduate the stop loss level upwards.

Stop loss can also work in reverse. You can set an upper limit - and if a share hits that limit you can take profits.

Stop loss means you may miss out if a share price soars. And in a highly volatile market the stop loss system may not function perfectly. If a share price collapses quickly it may suddently fall through your stop loss level, and before you have time to act it could be too late.

That said, not using the stop loss system means that you could get hammered by holding on to underperforming shares longer than you should.