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Don't invest in shares without it: The importance of a stop loss AND sticking to it

by , 11 June 2013

When you invest in shares, chances are you'll be thinking about the profits you'll be raking in. But it's crucial you also have an exit strategy if things go wrong. Read on to find out why a stop loss is essential for your portfolio…

When you start buying shares, you don’t buy them thinking you’ll make a loss. You’re more likely to be thinking about what you’re going to spend your profits on.

But, what happens when a share in your portfolio takes a dive?

To stop your emotions getting in the way, you need to employ stop losses, explains the Red Hot Penny Shares team…

What is a stop loss?

Stop losses are set as a percentage of the current share price.

For example:

If a share’s trading at 100c, a typical 25% stop loss would be set at 75c (100c minus 25% of 100c). If the price rises, so does the stop loss. If the share hits 120c, the stop loss increases to 90c (120c minus 25% of 120c).

Although stop losses can rise with the share price, they never fall.

So in our example, if the shares fall to 90c and hits the stop loss, you sell immediately.

Why bother setting a stop loss?

A stop loss system stops you from holding onto investments where it’s apparent you’ve made a mistake or unforeseen circumstances have moved against you. We all find it hard to sell a share at a loss, but it’s usually prudent to cut your position and minimise the loss before the situation deteriorates further.

Applying a stop loss forces you to do this.

But where do you set your stop loss?

It’s up to you really, but here are some guidelines that’ll help depending on your risk appetite:

At 25%?
This is a relatively sensitive level. It could mean, especially in today’s volatile markets, you cut positions wrongly. It also means you’re buying and selling a lot of shares, but you’ll let some real long-term winners escape your clutches. On the other hand, you’ll always avoid the real horror stories.

At 50%?
This is a relatively insensitive level. But unless you take a relatively proactive attitude to weeding out perennial laggards within your portfolio, you could find yourself lumbered with some underperformers. The level may help protect you against a disaster share, but it won’t absolve you from the tough decision of when to sell an underperforming investment.

What stop loss is right for you?

This comes down to your own attitude to risk. If you’re a very cautious investor you might tend towards 10%. If you’re more speculative, you might go with 50%.

Selling a share is never easy, but if you stick with a stop loss, over the long-term you’ll be glad you did.

Don't invest in shares without it: The importance of a stop loss AND sticking to it
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