Stop and Think Before Using Stop Losses

Stock-Picking

The last problem I see with stop orders is the stock selection aspect. At some point in your stock-picking process, you had to decide which stock of say, two was the better choice.

So if the "better choice" goes down 8%, are you automatically going to buy what you previously thought was second-best? I sure hope not; remember, you've got to check your first-choice stock's risk profile, put its decline in context and be aware of the possibility that it's at bottom.

Tailor Your Strategy

I'm not saying that stop orders should be avoided; quite the opposite. Stop orders can be very useful, if you understand the limitations of this type of exit strategy and don't use them in an arbitrary manner.

I am all for having exit strategies. Just tailor each exit strategy to the specifics of each stock; a utility stock should have a different exit strategy from a biotech stock.

Also, know the reason you want to sell each stock you hold; that should be factored in to your process. For example, if you buy a stock because it is a proxy for a foreign country but it fails to correlate with that country, you probably want to sell. Or if you want a brokerage stock, you go through the process of narrowing down the field of possibilities to what you believe is the better choice. If your first choice proves wrong (and you've of course determined during your selection process what would make it "wrong"), it behooves you to sell and switch to your "second choice," or even to switch sectors.

The possibilities are endless. If you're going to manage your own portfolio, you need to be willing to adapt the manner in which you take defensive action.

This column was originally published on RealMoney on July 27, 2007 at 11:30 a.m. ET. For more information about subscribing to RealMoney, please click here.

>To order reprints of this article, click here: Reprints