you have an exit strategy?
In 2008-2009, did your investments drop 10%? 20%? 50% or more?
Risk control is one of, if not the most, important part of investing. One facet of risk control is a prudent exit strategy.
Buy and hold has an undefined exit strategy; hence an undefined risk. It is cross your fingers and pray. Buy and hope does not really limit risk. Diversification limits certain types of risk but did not do well in 2008-09. And it does not help if a stock goes down 60%. Note when I say stock I'm referring to an investment: stock, bond, REIT, ETF, etc.
An exit strategy limits risk. With no exit strategy, your risk
is 100% of your investment (or more if leveraged).
You cannot control how much an investment will go up, but you can control how much it can go down. And you can control any profits the market has given you.
A simple stop loss can help prevent catastrophic losses. Say your investments in 2008 had a trailing stop loss of 10%. The most you would lose is 10% rather than cliff jump of over 50%. Stop losses are but one of many ways to limit your investments from losing a bunch.
One thing to consider when using a stop loss is the liquidity of the investment. Liquid investments can be sold easily and at or near your stop while an illiquid investment does not have that luxury.
Many knowledgeable and professional investors control risk very precisely by a procedure commonly known as money management or more accurately "position sizing". However, in order to accurately decide the size of the position to buy, we first have to know where we will exit if we are wrong so that we can calculate our risk. Example: We are going to buy our stock at $50 a share and we know that our account size is $100,000. We want to limit our risk to a maximum of 2% of our capital or $2,000. Our exit point on the trade will be $40 so we are risking $10 per share. We then divide our $2,000 maximum risk amount by the $10 per share that we are risking and we know that our correct position size is 200 shares.
No matter what exit strategy you use, nothing can prevent you
from being subject to a gap down. If you had set your contingent
order with your broker, then that order will be executed at the
best available price at that time. That price could be lower than
the stop loss trigger. The good news is that the stop loss helps
ensure you are out of a hard-falling stock, as typically gaps are
indicative of further downward behavior.
There are a wide variety of factors that can cause a stock to lose value. But by leveraging a stop loss to set contingent sell orders with your online broker, you can rest assured that at least the loss will be limited. Stocks can also “gap down”, and in those situations, your actual exit price may be lower than the triggered conditional stop you placed. We recommend that your contingent exit orders be placed as “market” vs. “limit” orders so that your exit will be implemented regardless of the price. An order to exit at a “limit” price offers no valid protection against a runaway break to the downside.