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Stop Losses - Protection from the Stock Market

By John Dietz - Email Editor

Date: 03-Jan-2006

In the investment world, a widely touted strategy for safety while buying stocks is the use of a Trailing Stop Loss. The way it works is if you buy a stock that starts to lose value, the Stop Loss Strategy lets you sell the security before it loses too much or all of its value. The basic strategy of a Stop Loss is to limit your downside risk.

The system most employed is a 25 percent limit on any one stock, meaning at any time if the price of the stock you purchased goes 25 percent lower in value from your purchase price, you would sell. So the maximum downside on any one stock is 25 percent. The caveat here is that you never put more than 4 percent of your portfolio into one stock or idea. Mathematics is amazing: If you use this system, you will never lose more that 1 percent of your portfolio on any one stock. The idea is simple: limit your downside risk to 1 percent while having the luxury of letting your winners go as far as they can.

Example
Here’s a quick example for the not-so-stock minded. You have a 1 million-investment portfolio. You buy XYZ stock with 4 percent of your portfolio. Multiply 1 million x 4 percent = $40,000. You own $40,000 of XYZ stock. You lose 25 percent of your $40,000 = $10,000. You were stopped out (you sell all your shares). $10,000 of loss represents 1 percent of your total investment portfolio. You have limited your downside risk to only 1 percent on XYZ stock.

While none of this is meant as investment advice, it is simply an illustration of a basic investment strategy. This strategy is the same approach that we should employ for Asset Protection. No matter how you lose net worth, it’s still a loss (most of the time it's after tax capital). So the big question is how can you live, work, and invest, while at the same time limit your downside risk of creditor attack?

The Basics: Divide And Conquer
Separating your liability generating assets will help to limit your downside risk. For example, if you owned a free and clear piece of real estate, your downside risk is 100 percent or more for this asset. If we encumber it, and the bank will give us 80 percent loan to value (probably more), we have just added a Stop Loss. At each Asset Protection turn, we should employ strategies that limit our downside risk.

Stealth Matters
In my stock scenario, one of the things all stock pickers tell you is to never let your broker know that you have a Trailing Stop Strategy. Giving your broker your Trialing Stops (good until cancel orders) is showing all the market makers at what price you are willing to sell. Asset Protection and stocks are a little like playing poker: You’re better off not showing your hand. Stealth matters; it’s not everything, but it matters.

In the end, no one can stop you from being sued. Well thought out, legitimate Asset Protection Planning will always limit your downside risk. As you are probably aware, the best plans are never used.

Most litigators will choose a pile of net worth sitting right in front of them, rather than have to jump through hula-hoops to make a payday. In the end, it’s the cream off the top that most lawsuits are based on.

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