I really loathe stocks as an asset class. I do.
And I own stocks!
But the reason I hate stocks is that they promise nothing. When you become the owner of a publicly traded company’s shares, you are given no claim to profits, property, or growth.
Go ahead and check the fine print on your shareholdings. You don’t own anything. Yes, you might receive dividends, but dividend income isn’t guaranteed. Companies can and do cut or eliminate dividends all of the time.
All you own as a minority shareholder is a piece of paper (or some ones and zeroes) saying so.
Now, you might say that even as a minority shareholder, you lay some claim to the company in the event of a total liquidation. And I’m sure that’s the case.
But consider who you’re in line behind to get a piece of the company in the event of liquidation – which is essentially the worst case scenario for any company.
You’re behind senior debt holders – including bond holders and secured debt holders – people like Warren Buffett.
You’re in line behind the company’s creditors – like vendors, utilities, banks, and other business partners who may have unsettled account balances.
You’re in line behind the IRS. Any taxes past due will get paid before you do as a shareholder.
You’re behind employees who are owed back-pay! So after the janitor gets paid. After the bookkeeper. After the assistant secretaries, and the bondholders, and Warren Buffett and Uncle Sam get their cut, then you get to pick up any pieces that are left.
So, it’s not likely that you’ll get paid anything. And that’s how you should look at any investment you have – through the prism of the worst case scenario.
But too many investors look at each investment through the prism of the best case scenario. Yes, in the best case scenario your dividend payments will rise every quarter, and the company will get bought out for a 100% premium, and President Obama will lower your personal capital gains taxes to zero.
Could it happen?
Yeah – but you don’t need to be aware of the best case scenario. The best case scenario won’t make you go broke. You need to be acutely aware of the worst case scenario.
And the worst case scenario will happen! Just ask folks who bought Puda Coal on my recommendation last year. The stock cratered and shareholders aren’t likely to get anything.
As I said, I don’t like stocks. But they can be a great way to build wealth. The question isn’t “should you avoid stocks at all costs” but rather, “at what cost should you sell?”
I can’t tell you what that cost is, but you should have it in mind to create a plan for every investment.
So how can you plan to protect yourself?
I’d strongly recommend that you keep a trailing stop loss in mind for all of your investments. Yes – even gold, but especially on stocks.
Avoiding losses should be your primary objective as an investor.
I don’t know what stop-loss percentage is right for you, but you should have one.
Otherwise, you will experience a total loss at some point on an investment.
Two simple rules for using a stop loss strategy:
- Never enter you stop loss bid into the market. Keep mental stop losses and only sell when the stock closes below your mental price.
- Follow your stop loss strategy! If you have a stop loss in mind, write it down. If the investment closes below your stop loss price, you need to sell. Don’t make excuses or exceptions after the fact. You can always adjust your stop loss – but it should be while you’re still in the black, not after you’re in the red.
Follow these rules and you’ll be protected from the eventuality of a total loss.