Since 1925, small-cap stocks have posted more wins than any other asset class—2% to 5% a year more than their counterparts, mid-caps or large-caps—an advantage that compounds quickly.
That’s surely a strong case for owning small-cap stocks. But before you buy, it’s important to understand that small company stocks act differently from other stocks—and therefore must be handled differently.
One area in which small-cap stocks require special handling is in stop-losses.
As a general rule, I recommend stop-losses to protect your earned profits in small-cap stock positions. But because small-cap stocks act differently from most other types of stocks, there are additional considerations.
Generally, small-cap stocks demonstrate much greater price volatility than mid-cap or large-cap stocks—fluctuations of 15% or more are typical (and they don’t need specific company or news events to trigger the volatility). It’s therefore important to keep the stop-loss in your head, not as an order to your broker.
Let me give you an example of how using a stop-loss could have turned out to be a painful financial experience for me:
Over a decade ago, when I was invested in Monster Beverage (MNST), formerly Hansen Natural, the stock fell out of the sky. A single 600 sell-side transaction (at the time, about 15% of the average daily volume) sent the share price down 35% and I was instantly looking at a paper loss of $15,000. If I’d had a stop-loss in place, I’d have missed out on the best investment of my lifetime, as Hansen went on to give its early investors returns in excess of 30,000%.
The lesson here is that an investor can get paid very well for stomaching the motion sickness that comes from owning small-cap stocks, but you absolutely need to keep on your toes.
Beware Market Makers
Another potential downside to small-cap stop-losses is that they reveal your plans to the market makers.
A market maker is a broker-dealer firm that accepts the risk of holding a certain number of shares of a particular security in order to facilitate trading in that security. Each market maker competes for customers’ orders by displaying buy and sell quotations for a guaranteed number of shares. Once an order is received, the market maker immediately sells from its own inventory or seeks an offsetting order. This process takes seconds.
Market makers know when we place a sell order, so they can take out our stops by a penny in order to add the stock to their accounts.
To avoid this from happening, I recommend mental stop-losses, rather than actual stop-loss orders.
Stop-Losses to Preserve Your Gains
So right about now you’re wondering when stop-losses make sense.
I think a stop-loss is in order when you want to preserve the hard-earned gains you’ve achieved in a stock but you aren’t yet ready to book them.
Step one is to determine the lowest rate of return you’re willing to accept on the stock. Use the stop-loss as your own personal profit guideline. I usually stick with a return of 35%.
The rationale is that you want a stop-loss that’s low enough that it would be triggered only if demand for the company’s product has seriously deteriorated (you don’t want to get tossed out of a stock because the price wavered in a sour stock market).
If you are confident that the company and its markets are sound, you may want to lower your stop-loss.
But when the stock is acting poorly despite your optimism and prospects for the company, you may want to raise the stop-loss to a level that makes you comfortable.
What strategies do you prefer when setting stop-losses or mental stops?
*This post has been updated from a previously published version.