Before I dive into today’s article, I want to thank you for voting for your favorite new Kung Fu Finance logo! I really appreciate your help and feedback and have worked with the top two designers to narrow it down to the final two designs, a combination of the best-of-the-best from yesterday. Either of these can be printed on clear or white cards (e.g. the one on the right can be printed on a white card, and the one on the left can be printed on a clear card):
What do you think? If you’d like to put in one final vote you can do so here…THANK YOU!
Now onto today’s article!
It’s fascinating to see what other people think about financial issues and strategies, and whenever I set out to write a blog post about the “#1” or “Top 3” anything, I always google it first out of sheer curiosity to see what other people think and to see whether anyone has posted about that before. It’s fun!
And having promised you my “#1 Strategy for Dealing with Volatile Markets” in yesterday’s article, I thought I would see what other people think is the “#1” strategy for dealing with volatility, so I googled that this morning. Well lo and behold, the entire first page of google results is filled with large financial institutions and major “MSM” (Mainstream Media) news networks.
This shouldn’t be too surprising, as these huge institutions and news networks will have a much higher page rank than most, but I was so saddened to see this….because of course their “#1 Strategy for Dealing with Volitile Markets” is a mix of “buy and hold”, “diversify” (and by “diversify” they list stocks and bond funds…no mention of any other asset classes), and of course “invest for the long-term: don’t worry about short-term set-backs because in the long-term the S&P 500 always goes up”.
Ugh. Do they think all of their readers are 20-year-olds who have 40-60 years to “ride out” these “inevitable downturns”? That’s insane! We need better strategies, and better answers!
So let’s get right to it. Here is my #1 strategy for dealing with volatile markets (and I happen to know it is a lot of other savvy investors’ #1 strategy, too!):
PROTECT YOUR DOWNSIDE…Use Trailing Stops!
One of the most important habits you can get into when investing is to use what are called “trailing stops”. This sounds so simple and obvious once it is explained, yet I am astonished at the number of “investors” who never use them (and I had never heard of them nor used them myself until I truly started financially educating myself many years ago).
Trailing stops accomplish something extremely important when you are trying to build wealth—they limit your losses. This is absolutely critical when investing, and has the side-benefit of forcing you to be self-disciplined, which is a key trait that all successful “smart money” investors possess.
As Warren Buffett famously said regarding his “Two Rules of Investing”,
“Rule #1: Don’t Lose Money, and
Rule #2: See Rule #1”
Smart money knows that in order to build wealth, you must protect yourself from catastrophic losses, and trailing stops are a terrific-yet-simple way of achieving this.
What is a Trailing Stop?
Say you purchase a share of stock (or heaven forbid, a crappy expensive mutual fund in your 401k…) for $100. A trailing stop means that if your new stock closes below $75, you SELL your share no matter what. (This is the “discipline” part—note that you sell the stock and realize the 25% loss, you do not “hang on and hope that it goes up again” the next week/month/etc.)
You can either enter this order into the market (not recommended for a variety of reasons), keep track of it yourself (via a spreadsheet, pen and paper, mental note), or use a notification service such as TradeStops.com that will automatically email you or send you a text message when your trailing stop has been “hit”. (Yes, it is that simple!)
Regardless of how you track your trailing stop, if your stock closes below $75 you sell. This simple strategy limits your losses to your predefined acceptable target (in our case, 25%, but you can use whatever percentage you are comfortable with and that makes sense in your situation—many investors use 15%, 10%….it’s up to you, but 25% works for a majority of cases). Using this extremely simple-yet-effective strategy, you have just saved your portfolio from a catastrophic loss!
And what happens if your stock goes up? Maybe it rises to $150 over the next few weeks…hooray! Well, your little trailing stop “trails” your stock price up and maintains the same “distance” from the new price, so if your stock is now at $150, your “new” trailing stop is now $112.50. Now, if your stock closes below $112.50, you sell it the next day.
In this way, you are continually limiting your losses, letting your winners “run”, and exercising self-discipline—three of the most important hallmarks of successful, “smart money” investors.
This simple, basic technique can save you from a WORLD of hurt financially. Imagine if you had heard of and had implemented a trailing stop strategy in the 2000-2001 Dot-Com/NASDAQ crash or the 2008-2009 subprime mortgage crisis? Imagine how much more money you would have today and how much more robust your portfolio would be!
You can see from the figure below, using the NASDAQ as an example, you could have “stopped out” either on April 3, 2000 with a 15% trailing stop, or on April 12, 2000 with a 25% trailing stop.
You could have ridden it all the way down to its close at the end of the year 2000 at 2470.52 for a massive loss of 51% and “hoped” it would recover, or…
You could have continued to ride it down until the end of 2001 where it closed at 1987.26 for an even greater loss of 61%.
The NASDAQ actually has yet to recover…as of 12/29/2011 the NASDAQ closed at 2613.74, still down 48% from its peak in March 2000.
As you can see, this wonderful little trailing stop strategy can save you a bundle in losses, and it will help to protect you from all kinds of market craziness in the year ahead!
Remember, as Bruce Lee said,
“Simplicity is the key to brilliance. It is not the daily increase but the daily decrease; hack away at the unessential. The height of cultivation always runs to simplicity.”
Use the trailing stop strategy. It might not be “sexy” or “complex”, but it works!
To your financial success,
—Kung Fu Girl