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Apprenticed Investor: Protect Your Backside

By the fourth quarter of 2001, stories were regularly appearing in the media about Enron's accounting issues . One day in October, after a particularly troublesome article, the stock "gapped down" at the open. Kenny's stop loss kicked in -- but not at $25.50 (15% below $30) as hoped for. Kenny Boy used a market -- as opposed to a limit -- stop-loss order. When the stock hit his number, his stop sell became a market order. The stock never traded at his number but "gapped down" to the lower price.

The gap down made poor Kenny Boy's execution awful; he was stopped out (for the third time), at $22.50 for a 25% loss.

Before we total Kenny Boy's losses, please note that he had the worst possible timing and execution possible. He bought at the top, got stopped out all three times, and even had a gap down which made his final sell much worse than expected.

Total damages: $30,000, or 33% of Kenny Boy's initial capital. That sounds pretty awful -- until you compare it with those people who did not have a stop loss plan in effect. These so-called long-term holders (also known as "deer in the headlights"), lost 99.89% of their capital. Their $90,000 initial purchase is now worth $110!

But unlucky Kenny Boy -- with a disciplined stop loss plan in effect -- still had $60,000 of capital left. The "buy and hold" crowd losses were 100% while Kenny Boy's were 30%. That's a huge difference.

Conclusion

Enron stands as important lesson in risk management and loss limitations. Jumbo losers can occur in any publicly traded company. Even "safe stocks" such as Exxon Mobil, GE and Microsoft are not exempt. Equities are volatile, and require a well thought out risk-management plan.

The key to avoiding catastrophic losses in any stock is in recognizing when institutions are dumping their shares and getting out of their way. As we have noted before, investors who fail to learn this lesson get trampled by elephants.

Barry Ritholtz is chief market strategist for Maxim Group, where his research and market analysis are used by the firm's portfolio managers and clients in the U.S., Europe and Japan. He also publishes The Big Picture, his macro perspectives on the economy and geopolitics, entertainment and technology industries, and is a member of the board of directors of Burst.com, a streaming media software company. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Ritholtz appreciates your feedback; click here to send him an email.

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