Since 1925, small-cap stocks have posted greater gains than any other asset class—2% to 5% a year more than mid-sized and large-cap stocks. That’s surely a strong case for owning small-cap stocks, but they need to be handled differently from other stocks.
As a general rule, I recommend stop-losses to preserve your hard-earned gains in stocks that you’re not yet ready to exit. I also recommend that you use mental stop-losses so you don’t reveal your plans to the market makers.
Because 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 events to trigger the volatility)—it’s important to keep a close eye on your stop-loss.
To set a stop-loss, start by determining the lowest rate of return you’re willing to accept on the stock. I usually stick with a return of 35%.
Two points to bear in mind when you’re setting a target price for your stop loss:
First, you want a stop-loss that’s low enough that its triggering would signal that demand for the company’s product has deteriorated (you don’t want to get tossed out of a stock simply because the price wavered in a sour stock market). Use the stop-loss as your own personal profit guideline. If the company and its markets are sound, then by all means lower your stop-loss.
Second, there are cases when a stock acts sickly despite your optimism and high prospects for the company. In these cases, you need to make a judgment call. The ultimate goal is to maintain your peace of mind, so if you can determine your threshold of pain in the investment, you should set your stop-loss above that level.