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Monday, January 26, 2015
We're in the midst of one of the longest bull markets in history... And opinions are flying.
Are we set to enjoy another year or two of big gains? Or are stocks about to crash in 2008 fashion?
Our colleague Porter Stansberry believes the stock market is set for a huge correction this year. He believes governments around the world have borrowed and spent too much money. They've taken on financial obligations they can't possibly repay.
We believe the risks Porter cites are a big concern. But we believe the stock market needs to bring in more public investors before hurting them with a bear market. That's just the way the market works. Drawing in more public investors will require at least another year of stocks rising. Our colleague Steve Sjuggerud is also in this camp.
It can seem like a big disagreement. But if you're using smart asset allocation, smart position sizing, and trailing stop losses, you'll be just fine... no matter which opinion you follow...
Earlier this month, we wrote an issue focused on the single most important factor that will get you through a financial crisis... asset allocation. The idea is to spread your wealth around in different asset classes... to be diversified. You want to own some gold, some cash, some real estate, some stakes in great businesses, and some trading positions.
We write about this vital idea so much that we're confident you've taken action. But given the possibility of a bear market ahead, how should you manage your stock holdings?
The answer is much simpler than you might expect.
Use trailing stop losses.
A trailing stop loss is a predetermined price at which you will exit a stock holding. It literally stops a loss. It's calculated as a percentage below a stock's highest recent price. For example, let's say you buy a stock at $10 per share and use a 15% trailing stop. If the stock rises to $20, you sell the stock if it falls 15% to $17.
The beauty of trailing stop losses is that they allow you to stay long during the uptrend... while providing a pre-determined plan for exiting positions when the trend turns lower.
To get an idea of how trailing stop losses can allow you to sidestep market crashes, let's look at how they performed in advance of the horrible 2007/2008 stock market crash.
Let's say you bought an S&P 500 index fund in the beginning of 2004... And you were using a 15% trailing stop.
As you can see in the chart below, you stayed in the market for the full run higher. Your trailing stop kicked you out on January 18, 2008... only after the S&P 500 fell 15% from its peak (and hit 1,325). You came away with a 19% gain on your investment.
In the next chart, you can see getting out at 1,325 saved you from taking major losses. The index didn't bottom until March 2009. The low was 677... 49% below where you exited.
It was a huge crash. And trailing stops would have allowed you to avoid the worst of it. They allowed you to ride the uptrend and cash out with profits.
If you had a 30% allocation to stocks – which is the upper range of the asset allocation we laid out in our earlier essay – and if you stopped out 15% below the peak, you would have added 5.7% to your total wealth. (That's the 19% profit times the 30% asset allocation.)
Now imagine you bought the same index at the same time... but had all of your savings in stocks, and didn't use a stop loss. Your net worth would have dropped 39% from the beginning of 2004 to the March 2009 bottom.
This is a powerful example of how trailing stop losses married with smart asset allocation can make you and your portfolio extremely robust... and able to handle big stock market declines.
Are the folks predicting a bear market right? Or are the bulls right?
We can't know the future. We can only stay aware of the possibilities and structure our portfolios to handle them. If you employ the risk-limiting strategies we've described today, you'll stay diversified. And you'll be prepared for either situation.
Brian Hunt and Ben Morris
P.S. We don't recommend entering your stop losses with your broker. It's like playing poker with your hand showing... And other market participants can take advantage. Instead, we recommend you set alerts to let you know when the share price closes below your stop. Learn how to keep track of your stops here.
Or try out the "Cadillac" of alert services created by our corporate affiliate TradeStops. It will track "cost basis" stops, trailing stops, hard stops, and even technical indicators. It will also import information from your online broker. It retails for $299 a year. But you can get a big discount right here. (Sign up for the standard service, then look for an offer on TradeStops Pro.)
If you're ready to put the stop-loss strategy to work, learn everything you need to know right here:
The Trailing Stop Strategy
"If you follow the advice below... you'll never lose another night's sleep worrying about which way your investments will go tomorrow."
The Most Valuable Factor in Your Trading Success
"What's so great about a 25% stop loss?"