One of the great dangers when investing in shares is to fall in love with a share and then following it through all its ups and downs and potentially following it all the way down. The first share I did this with was Intel. I bought some Intel shares at $18, held them all the way up to $80 a share and held them all the way down to $18 again. So I hadn’t really lost anything (unless you compare with other things I could have invested in). It sure would have been nice if I could have locked in the gains when the share was at its highest, but even selling when it was at $60 a share would have been great (as I’m writing this, Intel is trading at around $26-$27).

It is more or less impossible to know when the best time for selling a share is, but stop-loss investing can help you lock in the gains or, well, stop the loss, depending on what is happening to the share price.

There are several variations of stop-loss investing. The one I prefer is the “trailing stop-loss” and it works as follows:
You initially decide how far you are willing to let the price of a share drop from its highest value (while you hold it). Let’s say that is 10%. The purpose is to set a limit to how much you are willing to lose without setting a limit on how much you can gain. It also enables you to lock in any gains there may have been. Let me illustrate with some examples:

Example 1, the price of the shares you have bought starts falling immediately after you bought them:
You buy a share at 100 ($, £ or €, it doesn’t matter).
Your stop-loss value is 100-10%=90. As long as the price doesn’t drop below that, you keep the shares.
Unfortunately, the price starts falling, it hits 90 and you sell the share.
That wasn’t great, you lost 10, but you have limited your loss to 10.

Example 2, the price of the shares you bought first increases for a while and then starts falling:
You buy a share at 100
The price increases to 120. This is the new value from which you calculate your stop-loss. Your stop-loss value is 120-10%=108. As long as the price doesn’t drop below that, you keep the shares.
The price increases to 140. This is the new value from which you calculate your stop-loss. Your stop-loss value is now 140-10%=126. As long as the price doesn’t drop below that, you keep the shares.
The share price does start dropping, it hits 126, and you sell the share.
That was better than example 1, you could have sold at 140, but who knew that was going to be the highest value it would reach, and you have locked in a gain of 26 rather than potentially holding on as it falls even further.

I regularly calculate what the stop-loss values of the shares in my portfolio are, but I don’t automatically sell a share that drops below its stop-loss value. Doing that can give you losses even though it is supposed to minimise them.

Several years ago, I bought shares in Citrix. A few months later, the share price dropped 75% in one day (Microsoft announced that it would bring out Terminal Server, a product with the same features as Citrix’s). The drop in price was so sudden that stop-loss investing wouldn’t have saved my skin (unless of course the share price would have continued to fall). Two months later, the share price went back up to its previous level as Microsoft announced that Terminal Server would be based on Citrix technology.

In the recent sub-prime credit crisis, I bought some shares that had fallen and I considered them a good buy. Shortly after, they fell even further (by about 20%) as the market panicked and sold anything related to the financial industry. A few days later the shares went back up to previous levels as investors found that these particular shares did not have exposure to the sub-prime credit crisis, and when Ben Bernanke lowered the interest rate, the price rose even further.

On the other hand, as illustrated with my Intel example, there have been times when a share has given me very good gains on paper, and where I later have followed the shares downwards, in one case all the way to bankruptcy. Had I used the stop-loss approach, I would have locked in my gains on some badly behaved shares.

Summary:
I would suggest you regularly calculate a stop-loss value for the various shares in your portfolio. If the price does drop below your stop-loss value, consider selling the share, but don’t do it on auto-pilot. There could very well be valid reasons to keep it (maybe it pays a high dividend). Consider also, that stop-loss investing doesn’t tell you to get rid of a share whose share price is motionless.

I have made a small, simple spreadsheet that illustrates the approach; you are welcome to download it. You are even more welcome to enhance it.

Click to download: Stop-loss.zip