Six Steps to Better Stop Losses

Stop losses are also a great portfolio-management tool because of the discipline they force on the investor. An effective stop-loss process forces you to evaluate both the upside and the downside before money is invested, and it forces you to commit to a specific time horizon. This is why stop losses merit your time and energy. While I don't claim to be the last word in setting stop losses, I've been a stock analyst and money manager for 20 years. And as the director of content of Street Insight, I work with dozens of money managers who have a wide variety of investment styles.

Yet it has been my exposure to technical analysis, however superficial, that has been most useful to setting my stop-loss levels. I believe that the process must integrate technical and fundamental analysis to be effective. Some would call this behavioral finance, but I'll spare you the lecture on regret aversion, hindsight bias and my personal favorite, "magical thinking." I like magic as much as the next guy, but there's no need to dress up common-sense investing as a secret statistical priesthood.

Putting It All Together
All of this sounds like a lot of work. But the example below is only a few lines long, and it comes from someone who sets stop losses effectively: Street Insight contributor Mark Thomas. This is from a recent The Long/Short Investor article in which he discusses his bullish views on CSX Corp. (CSX).

I think the stock could be worth $60 within six to nine months. I like the fact that the stock here at $54.40 has a potential upside of almost $6, with a potential downside of $3 (or a 2-to-1 reward-to-risk ratio). My stop loss is set at $51.40, the stock's low this February.

Now this doesn't exactly set the house on fire. Mark is not pounding the table, and he's only looking for about 10% upside. But CSX is a liquid stock with a low-risk profile, and the time horizon is well under a year. This is a well-defined trade with a stop loss that makes sense. So a 2-to-1 ratio of reward-to-risk is fine, and it is very clearly explained.