How to Not Ruin Your Portfolio

Today's article isn't really a screen (although I do have one at the end).

I want to talk about something that I believe is critically important in light of what's been happening in the market.

And that's about managing your risk -- using stops, cutting your losses -- all of that stuff.

Not a fun topic, but probably one of the most important for right now.

What's interesting is that nobody ruins their portfolio when the market is going straight up. It's when the market goes down that people get into real trouble.

But ironically, it's when the market is going up that a lot of these bad habits are created.

The problem is that even bad decisions are oftentimes rewarded in a bull market. But when the market is going down, there's no mercy for bad decision makers. Sitting on losses in hopes of them coming back can ruin your portfolio as they grow bigger.

I like using a 10% stop loss rule because it's kind of a tit for tat. If you lose 10% on a trade, you only need a little bit more than 10% to get that money back (11.1%).

But if you lose 20%, you now need a 25% gain to get that money back.

And it gets worse as it goes down.

If you lose 30%, you now need nearly a 43% return to get back to where you were.

And if you lose 50% -- you now need to pull out a 100% return to get back to even. (And if you're so slick that you can pull a 100% return out of your hat at any time, why did you just get clobbered for a 50% loss?!)

So I think it's important to keep your losses small.

Why do so many people find it hard to cut their losses short?

I think a lot of people hate taking losses because they fear that if they get out, and the market goes back up, they're going to miss out on the move.

Like somehow, they’re going to get out and it’s going to go up a million percent without them.

First off, that's nonsense.

Just give yourself permission to get back in.

If the stock does go back up and a big move ensues, the 10% you gave up won't really matter.

Of course, you don't want to get back in the moment it goes a tick above where you got out. Give it some proving room. But if there's a compelling reason to get back in, do so.

Don't hang onto losers for fear that they'll all of a sudden become big winners once you get out. You can always get back in. But every losing trade begins with the investor believing that it was going to be a big winner too – otherwise they wouldn't have made that trade in the first place.

In stocks, nobody is 100% right. So knowing that – take your losses when a trade is not working out and move on to another higher probability trade.

Plus, it can help you stay focused. By keeping your losses small, you won't get gun shy on your next trade.

Stock Screen

One of the ways to minimize your downside, in my opinion, is to find stocks outperforming the market.

A simple screen I've been running is to look for the top 100 companies that have outperformed the S&P 500 the most.

I add in the Zacks Rank and price and volume constraints (> $5 and > 100,000 shares) to first narrow the universe down. But then I'm looking for the top 100 stocks with the greatest Relative Percentage Price Change over the last 24 weeks.

And you get a lot of interesting companies across all different sectors and industries.

Here are 5 that came through this list for Tuesday, 9/16/08:

FRED - Analyst Report Fred’s Inc.
APSG - Snapshot Report Applied Signal technology
USNA - Snapshot Report USANA Health Sciences, Inc.
GIII - Snapshot Report G-III Apparel Group, Ltd.
FSYS - Snapshot Report Fuel Systems Solutions, Inc.

You can narrow this list down even more on whatever items you choose. Don’t forget to backtest your ideas too to make sure they work. Remember, the key to successful screening is in discovering those screens that have produced profitable results in the past. That’s exactly what you get with the powerful Screening and Backtesting ability of Research Wizard. You can do it. Learn how, today:

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Disclosure: Officers, directors and/or employees of Zacks Investment Research may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material. An affiliated investment advisory firm may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material.