I Was Foolish... But This Trick Kept Me Alive

I can't believe I did it... 

In hindsight, it was so foolish. But at the time, it made so much sense. 

A year ago, I bought shares of banks and homebuilders. I admit it, I was a fool. But they had the three things I want to see in an investment... 

Banks and homebuilders were:

1) Cheap – as cheap as they'd been in many years.
2) Hated – as hated as they'd ever been, judging by investor and homebuilder sentiment.
3) In what looked like the start of an uptrend.

With the benefit of hindsight, we now know the problems in banking and homebuilders were greater than almost anyone imagined. We now know the start of an uptrend I thought I saw didn't turn out to be an uptrend at all. And we now know that – even though things were as bad as we'd ever seen at homebuilders and banks – things could still get worse.

I got it completely wrong. But for being such a fool, I still did one thing right... 

I cut my losses.

With trailing stops, I limit my downside risk. In my newsletter, I usually recommend a trailing stop of 25%. That means you sell your investment if it is down more than 25% from its high point since you bought it. 

In the last few bull markets in homebuilders, homebuilding stocks have risen by hundreds of percent on average. So my upside was hundreds of percent. And my downside was wherever I set my trailing stop. I liked those odds.

Of course, I got it wrong. I took my lumps. But thanks to trailing stops, I didn't worry about it. When I'm wrong I move along... I don't keep pecking away at it, throwing good money after bad.

I even have a couple personal rules for not going back into something I stopped out of... I don't even consider going back in until 1) six months have passed or 2) the stock hits a new high. These rules keep me from doing dumb things like trying to be "right" by buying a stock lower and lower.

It's one of the nice things about trailing stops: You don't even have to be right half the time to make good money... 

For example, let's say I make three $100 investments at the same time. I get two wrong and lose 25% each, but make 100% on the one I got right. In the end, I did just fine... I turned $300 into a total of $350 (that's $75 plus $75 plus $200). 

Most importantly, trailing stops prevent you from experiencing "catastrophic" losses. Former blue chip Beazer Homes has fallen from $80 in 2006 to 45 cents today – a 99%+ fall. Bank of America has fallen from around $40 at the beginning of 2008 to less than $4 today – over a 90% fall.

It's not just banks and homebuilders... How 'bout GM? AIG? Fannie Mae? Who's next? You don't know. So consider this... 

If you lose 25%, you need to get a return of 33% to get back to where you started. But if you lose 50%, you need to get a 100% gain. And if you lose 75%, you need a 300% gain, and so on. You never want to be in a position of asking for a 100% gain from something that just fell 50%!

You might think, "It's too late now for trailing stops." Is it? You probably would have said the same thing a year ago. If you starting using them a year ago, chances are you could have saved a lot of your wealth.

It's never too late. The benefit of protecting yourself from a catastrophic loss is too great. It's the one thing that saved me, and my readers, in 2008.

Give trailing stops a try... 

Good investing,

Steve 

P.S. I use a little program called XLQ (at www.qmatix.com) to track my investments in Excel. But there's another handy program I think you should check out... 

A subscriber of mine, Dr. Richard Smith, created TradeStops, a simple and excellent way to track your trailing stops online and manage your portfolio. You can even receive an e-mail when your trailing stop is hit. For more info, click here.