How to use stop losses to protect your investment capital

Julie Brownlee, Fsp Invest, 20 Feb. 2015

Tags: stop losses, position sizing, investing, investment strategy, how to protect your capital, risk management,

Being a successful investor very much comes down to how you manage the losses of any investments you make.

Yes, you should know when it’s time to exit a profitable position too, but you’re never going to complain about making too much money on a share.

So how can you manage your losses?

One way is to limit your losses to a portion of your investment pot and use stop losses to manage it.

Read on to find out how this works…

Know how much you’re willing to lose before investing

Using stop losses as a way to manage your downside risk is effective.

But you can tweak the way you use stop losses so that you protect your investment capital regardless of how much you invest in a position. This is known as position sizing.

So how does it work?

The idea is to risk the same amount of money on each of your investments. The best way to see how this works is with the help of an example…

Position sizing in action

Let’s say you have R100,000 in your investment account. You decide to limit your losses to R1,000 for each investment you make.

Here’s how it would work out depending on the size of each of your investments if you decide to risk 1% of your capital:

  • You buy R5,000 worth of shares in Company ABC. To limit your potential losses to R1,000, you’d run a 20% stop loss ((R1,000/R5,000) x 100).
  • You buy R10,000 worth of shares in Company ABC. To limit your potential losses to R1,000, you’d run a 10% stop loss ((R1,000/R10,000) x 100).
  • You buy R20,000 worth of shares in Company ABC. To limit your potential losses to R1,000, you’d run a 5% stop loss ((R1,000/R20,000) x 100).

As you can see, the larger the amount you invest, to limit your losses to the amount you decide, the tighter your stop loss.

Running a tight stop loss can have its disadvantages. If there’s a lot of stock market volatility, it might trigger your stop loss. So this is something you’ll need to consider.

But this investment strategy is very effective at managing your investment pot. You just must ensure that you stick with your stop losses and strategy when you invest.

So there you have it, how to use stop losses to protect your investment capital.

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