Monday, May 17, 2010

Controlling Your Portfolio’s Destiny

I missed all of the excitement of the sudden stock market drop on May 6th. After digesting the events that evening, my thoughts were that it shouldn’t have hurt long-term investors who missed the whole thing. Prices went down, and if there was no good reason for it then prices should rebound. However, some investors were hurt even though they took no explicit action.

Stock market prices are an estimate of the actual value of real business assets. Many people see the stock market as some kind of casino, but over the long run stock prices reflect business value and not just the roll of the dice. This means that if the big price drop May 6th was just some trading glitch without any connection to business value, prices should rise back up again.

As a long-term investor, the whole thing was a big yawn. However, this is only because I avoid things that can cause automatic trading of my holdings. Investors need to make their own choices, but they should understand the risks they take. Here are a few things I prefer to avoid to maintain control over trading of my portfolio:


Stop-Loss Orders

Some investors like to set stop-loss orders that cause shares to be sold automatically if they drop to a certain price. The idea is to limit the potential loss. However, a big downward spike in prices followed by a sharp return can trigger a sale. Worse still, the sale may take place at a much lower price than expected if the shares couldn’t be sold at the stop-loss trigger point due to high volatility.

Investors can avoid a stop-loss sale taking place at a very low price using a stop-limit order. When the shares reach the stop price, a stop-limit order then triggers a limit order, but this defeats the usual purpose of the stop-loss. If the shares drive down through the stop-loss price and below the limit price as well, then the trade will not take place. This is good if the price ultimately rebounds, but bad if it doesn’t and the investor needed to avoid a big loss.

Margin

Margin means using borrowed money to buy equities. Brokerages follow rules to limit the amount of margin an investor can use. If equity prices drop to the point where the margin rules are broken, the brokerage begins selling the investor’s shares until the margin rules are satisfied once again. The May 6th stock market drop triggered some margin calls and some automatic trading. The rebound in stock prices didn’t help much for those whose shares were sold.

Authorizing a Trading Agent

A trading agent is someone you authorize to make trades in your account. I don’t mind listening to other people’s advice, but I prefer to control the final decision to take action.

I won’t say that stop-loss orders, using margin, and authorizing trading agents are always a bad idea. I just prefer to avoid them partly because I want to maintain more control over my portfolio.

4 comments:

  1. Those services are kind of like Insurance but in an odd way. They can do good things (get you nearly the least you want for a security if the market is "tanking"), but as last week shows, can be bad as well.

    I guess being dumb and lazy pays off again!

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  2. @Big Cajun Man: I don't know about the "dumb" part, but once you set up a reasonable portfolio, being lazy often pays off.

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  3. is there an opposite to a stop loss ?
    not sure if its a good idea but for example you can set your stop loss for $10 on the TSX index and if it continues going down maybe you can setup the opposite to buy TSX at $5.
    So if the market tanked like a couple of weeks ago, you just doubled your # of shares.

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  4. @Anonymous: What you're talking about would be just a limit order at $5. This is sometimes called a stink bid where you place a limit order at a low price in case the equity trades way down.

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