Financial planners and financial advisors may be conflicted as to how to manage their clients’ money in these volatile markets. The reality is that a strategy needs to be in place long before markets implode. The main two components of an effective strategy are to apply a stop-loss system and to have sufficient cash reserves in clients’ portfolios.
Most of the negatives of this strategy centre on how to execute and manage it, which can be overcome. In simple terms — although it’s far more complicated — a stop-loss order is an order to sell a security when it reaches a certain price. When a stock price is falling, the order reduces the loss. It can also be used when a stock price rises above a certain defined price, as the order is executed and locks in profits.
You can use this cash reserve and stop-loss investment strategy to help manage clients’ emotions in volatile markets. Clients may feel that they should never sell “low,” for example, or that particular stock is a good investment and will rebound in value; or that there is too much cash in their portfolios and they are missing out on a rising market index.
Steve Sjuggerud, editor of True Wealth, an investment advisory newsletter published by Baltimore-based Stansberry & Associates Investment Research LLC, recommends a trailing-stop strategy. He describes this as having an exit strategy that makes you cut your losses methodically and let your winners ride. One simple form of this strategy is the 25% rule: sell any and all positions at 25% off their highs. For example, if you buy a stock at $50, and it rises to $100, sell it when it closes below $75 — no matter what.
Furthermore, he cautions to not let your losers become big losers. There is nothing magical about the 25% rule; it’s the discipline that matters. “You never want to be in the position where a stock has fallen by 50% or more,” Sjuggerud says. “This means that the stock has to rise by 100% or more just to get you back to where it was when you bought it.”
Sjuggerud also addresses one of the main negatives of stop-loss orders: depending on the order type, stop-loss orders may not work. A stop-loss order is triggered when the stock trades below a certain price, and it will be sold at the next available market price. This works when markets are declining in an orderly manner, but not if the decline is disorderly or sharp. On the other hand, you can use a stop-limit order that will seek to sell the stock at a specified limit — rather than the market price — once a specified price level is breached. This type of stop-loss order will also not work if the stock is halted or has a price gap — a sharp move up or down.
To counteract these technical gaps, he recommends not placing actual stop orders, but selling the day after the stock hits your specified stop because traders normally aggregate all stop orders together and sell at the worst price.
Michael Sincere, a columnist with MarketWatch.com, believes in a stop-loss strategy but not the automatic kind. He contends that with technology so prevalent, using price alerts that inform you your stop loss has been reached, then making a trade manually, is a more effective strategy.
Andy Crowder, a professional options trader, research analyst and financial columnist with Wyatt Investment Research, further demonstrates the power of a good stop-loss strategy in long-term portfolio management. He suggests using volatility-based stop-loss orders based on probabilities attached to an individual stock’s volatility. Under this system, a typical blue-chip stock will have less risk and less weighting in the overall stop-loss percentage than a standard small-cap stock. The outcome is a stop-loss strategy that will protect the overall portfolio’s value better in volatile markets and limit the havoc that any one stock can create within your clients’ portfolios.
The other important component of a stop-loss strategy is to keep at least 25% cash reserve in clients’ portfolios so that you can purchase well priced stocks of excellent companies in falling markets once lows have been realized. Having a stop-loss strategy to dispose of losers orderly and raise cash to take advantage of such opportunities will be more effective than picking arbitrarily between winners and losers and selling under the pressure of volatile markets.
For financial planners and advisors, there are major opportunities in volatile markets as you can both protect the value of clients’ investments and position their portfolios for long-term growth by employing a stop-loss investment strategy that will withstand the stresses of these turbulent market forces and well planned cash on hand.