You’re Engaged! Let the planning begin…

Anne Bednarz, CFP®, AIF® Financial Advisor

Congratulations on your upcoming marriage! It’s an exciting time in your life, with a new chapter to begin with your love and your lives together. Let the planning begin for the big day; it is also a good time to tackle a topic that will affect you long after your wedding day. This is an essential time to discuss your finances. Where are you currently? Where will you be after your wedding day? What are your long-term goals for the next five to ten years and beyond? By setting the tone prior to your wedding day and knowing what your goals are, you can work together as a team to accomplish them.

Where are you each currently?

How much do each of you bring to the marriage? Is it in a bank account, a retirement account, other assets, or debt? Bring it all to the table so each of you knows exactly what you’re stepping into. What are your spending habits? Do you live paycheck to paycheck, or are you a saver? Often opposites attract, so this could be an important discussion point for you.

Do you live in a common law state or a community property state? (Community property states are Louisiana, Arizona, California, Texas, Washington, Idaho, Nevada, New Mexico and Wisconsin.) This is particularly important for those in community property states. Anything that you own prior to marriage will remain your own in a community property state, and anything that is earned, purchased, or comingled during the marriage could be considered joint property. Will you keep these assets separate or combine them?

If you bring debt to the table, what type of debt is it? Do you own your own business and have business debt that you are personally responsible for, or do you have consumer or student loan debt? If it is student loan debt, there are several ways to approach how to pay it off, and a personal financial planner can help you understand the best way for you and your spouse to approach it. Some types of student loans can lose their potential loan forgiveness characteristic if not treated properly. Tread carefully.

How to conquer everyday living

How will you approach your everyday living situation… will you divide and conquer, or will you both take it on jointly? This is also a good time to sit down and make a joint spending plan. What items are essential for each of you beyond basic living expenses?

There are several approaches when setting up your finances together:

1. You can combine everything and have a joint account from which you both spend.
2. You can keep separate accounts. Each of you is responsible for one-half of the bills, or depending on earnings, keep it proportional to the income you earn.
3. A combination approach. Have a joint account to pay for the basic joint bills, utilities, rent/mortgage, insurance, etc. Then have your separate accounts to pay for any separate debt obligations, or separate spending money for what you consider essential.

It is also a good idea to set boundaries for what amounts are okay to spend without seeking your spouse’s consent versus making an expensive purchase without consulting your spouse and possibly damaging your financial trust. As many of us have read, the divorce rate in the US is roughly 40 to 50%,¹ and a common issue is money. If one of you handles the money most of the time, then set aside a time each month to review what is happening so you both are in the loop.

Future Goals — Do a little dreaming…

What would you each like to accomplish in the future? Write down the goal, the amount it is expected to cost, and the estimated time horizon. Revisit your goals each year, and modify them as needed. Life happens, and the best laid plans get interrupted, but being able to adjust and move on is essential in life.

For example:

Year 1:

1. Start retirement savings accounts.
2. Maximize the amount that your employer contributes.
3. Set up an adequate emergency fund.
   1. 3–6 times your monthly expenses
4. Set up a debt reduction schedule.

Year 3: Pay off all your student loan(s) by your third anniversary.

Year 5: Purchase your first home for $X.

Year 10: Purchase a boat or recreational vehicle for $X.

As uncomfortable as it may be, it’s also a good time to discuss your current financial situation now, rather than later. You will both be able to have a better understanding of where you were coming from and where you are going in the future. Enjoy your engagement and prepare for your life together.

Feel free to contact Anne Bednarz, CFP® with any questions by phone 806.747.7995 or email: ABednarz@EK-FF.com

¹ American Psychological Association: Marriage & Divorce, http://www.apa.org/topics/divorce/

Umbrellas and Bumbershoots: How Risky Investments Can Make for a Safer Portfolio

Harold Evensky CFP® , AIF® Chairman

Harold Evensky: Good morning, class.

Class: Good morning, Professor Evensky.

Andrew: Professor Evensky, why are you carrying that umbrella? The temperature outside is 110 degrees and it hasn’t rained in the past three months!

HE: Andrew, that’s an excellent question. And this umbrella is what we call a prop. It will help introduce one of the most important issues in wealth management: diversification and asset allocation, and why they’re so important in helping our clients meet their goals.

Elizabeth: Professor Evensky, will this be on the test?

HE: So I’ve prepared a little exercise to help all of us think through how to make investment recommendations in light of client goals. Is everybody ready?

Class: Yes.

HE: In this exercise, our clients live in a simple world where they have a choice of only three investments. Two of them are risky. I’ll write the choices here on the whiteboard:

HE: Everybody got that? As a sophisticated planner, you recognize that the swimsuit and umbrella company stocks are very risky, since an investor will either make a great return or no return, depending on the weather. So you’ve consulted with some of the world’s greatest meteorologists and arrived at the following:

 

Meteorologists’ Predictions

80 percent probability that it will be rainy 90 percent of the time

60 percent probability that it will be rainy 70 percent of the time

30 percent probability that it will be rainy only 20 percent of the time

 

How would you recommend my clients allocate their investments? Where do you start?

Andrew: Well, you say we should always start with what we know about our clients.

HE: Great start, Andrew. And what important things do we know about them?

Andrew: To achieve their goals, they need at least a 10 percent return. We also know they are not very tolerant of investment volatility. They don’t like their investments to bounce around a lot.

HE: Good so far. Kiran, where does that take us?

Kiran: Only now should we look at the investments. We should look at the possible investment outcomes—which, in this case, seem to depend on the weather.

Nicholas: Professor Evensky, while everybody else was chattering on about the clients, I made up a little table that shows all the different possible portfolio returns based on the weather data you gave us.

HE: Thank you, Nicholas.

Nicholas: I also created a neat little algorithm that will do these same calculations if we ever run into a problem like this again. I could show you after class.

HE: Nicholas, I’m going to go out on a limb and predict that you have a bright future as an investment analyst.

Nicholas: Whatever. Wait. That doesn’t mean I’ll have to talk to actual people, does it?

Carly: Professor Evensky, I’ll check Nicholas’s math.

HE: Thank you, Carly. So does everybody see where the numbers come from?

Suppose, for example, you have 90 percent allocated to umbrellas and it rains 70 percent of the time. That means you will profit from all of the 70 percent rainy days. That’s a net of 14 percent to 20 percent, maximum, times 70 percent, right, Nicholas?

Nicholas: Obviously.

HE: Okay, now let’s consider how we did with our swimsuit company investment. Since only 10 percent is invested in the swimsuit company, and there are 30 percent sunny days, the swimsuit company can profit from only some of those sunny days. So my return is 20 percent, maximum, times the 10 percent I have invested in swimsuits, which equals 2 percent. Add 2 percent return from swimsuits to 14 percent return from umbrellas, and you get a total of 16 percent. If this turns out to be the real weather pattern, I didn’t get the full 20 percent because I owned too many umbrellas and not enough swimsuits.

Kiran: And that’s where all the other possibilities came from?

HE: Correct. You can use the same process to calculate the other figures in the chart. So now what? Do you have an answer to the proper allocation for these clients who need 10 percent a year and don’t like a lot of volatility?

Alicia: Well, I guess we have to toss out the safe investment.

HE: Good, Alicia. Why?

Alicia: At a fixed 8 percent, the CD is a nonstarter. For someone who needs 10 percent, only receiving 8 percent, no matter how guaranteed, would be a failure.

HE: Good thinking. Of course, when you present the alternatives, our client might elect to revise the goals so that 8 percent would suffice. But before we recommend that, let’s look at the risky alternatives. What do you see here?

Kiran: I’d apply Modern Portfolio Theory, and come up with a blend of the risky investments. If you blend investments that respond differently to different investment climates, then the result is a portfolio with less volatility.

HE: Very good. And did y’all get my joke? Investment climate—rain or sun—pretty funny, right?

Kiran: Professor Evensky, maybe you shouldn’t try to be funny in class.

HE: Yes, well, the important thing is that we can blend these risky investments. And in this simplified investment world we’ve created, what do you notice immediately?

Alicia: The risk and return patterns are exactly the opposite. You make money in swimsuits when it’s sunny, and when it rains, your return comes from umbrellas. It either rains or it doesn’t.

HE: Right. So?

Alicia: So in that simplified investment world, if we put half in swimsuits and half in umbrellas, we’d always be making 20 percent on half of our portfolio and 0 percent on the other half.

HE: And?

Andrew: For these clients, if they invest half of their money in swimsuits and half in umbrellas, no matter what happens, even if it never rains again or the deluge never ends, or anything in between, the clients will get a guaranteed 10 percent return—which is exactly what the client needs.

HE: Excellent. Of course, in the real world, you probably have thousands of different drivers of the profits of tens of thousands of different companies. If you were to bet on any one of them, there’s the possibility that whatever you were betting on, just the opposite would happen and you could lose a lot of money. But if you spread your bets around, and the economy grows—which it has done since people were living in caves—then all of those bets across all of those different drivers will smooth out some of the ups and downs. And there’s a high probability, based on history, that your clients will get returns commensurate with their willingness to wade into the world of market risk. Diversification really works.

Kiran: But there’s still risk, right?

HE: Of course. The moral here is not that you can eliminate risk; but in designing your portfolio and evaluating risk, you need to consider the risk of the combined investments, not the risk of each individual investment. And let’s not miss something equally important: you need to consider the risk of not achieving your goals by confusing certainty and safety. Does everybody get it?

Class: Yes, Professor Evensky.

HE: And yes, Elizabeth, this will be on the test.

Elizabeth: What’s that?

HE: But I wanted to get back to something we talked about earlier. Who thought that my investment climate joke was funny? And try to keep in mind that your grade might depend on it.

This blog is a chapter from Harold Evensky’s “Hello Harold: A Veteran Financial Advisor Shares Stories to Help Make You Be a Better Investor”. Available for purchase on Amazon.

Credit Card Benefits

Josh Mungavin CFP®, CRC® Principal, Wealth Manager

Credit cards can come with significant benefits, many of which are commonly overlooked. As significant value can be derived from credit card benefits, it’s important to understand the benefits both of currently owned credit cards and potential new and better credit cards. Having the best credit card for personal use and taking advantage of everything it offers can add substantial value over time. Obviously, one of the most focused-on benefits is the reward program that is advertised with a card, but that is not everything that you get when you use a credit card to its full potential.

Purchases

Some credit cards protect your purchases and provide options if anything should go wrong with a purchase, or if the price of your purchase is reduced in the near-term future. Here is a list of some of the different types of purchase protections that credit cards can have.

Price Protection — This benefit allows you to buy something and get a partial refund if the item goes on sale during a set period of time. This generally requires that you register the purchase with the credit card on the credit card’s website and then petition the credit card company to refund the difference in price. Obviously, you would not want to do this for every small purchase, but for some large purchases, especially those purchases that have a history of price volatility, it may very well be worth your while to put them under the price watch for your credit card and to check during the time price protection is available on that item to see if the price decreases.

Purchase Protection Insurance — This benefit covers you in the case of theft or damage of a newly-purchased item within a given period of time. This can be used strategically. For example, this coverage could be used if you intend to purchase a new phone and have a trip coming up in an area of the world that is prone to pickpocketing and theft. You can coordinate the purchase of a new phone with the Theft Protection coverage on your credit card so that you don’t have to take an old phone or worry about your new phone being stolen while you are on vacation.

Extended Warranty Protection — This benefit extends the manufacturer warranty on purchases for a certain amount of time. This may mean the offer to purchase an extended warranty may be of much lower value than it would have been otherwise, had you not had the coverage from your credit card. Obviously, you need to know the details of how this type of coverage works before making any warranty decision for any large purchases. It is always worth checking on any potential insurance coverage from your credit card before you purchase an extended warranty or a replacement product at your own expense, as you may have a warranty that you did not know you had through your credit card company.

Some credit cards will even refund the amount of a purchase if the store where the purchase was made will not accept a return.

Travel Benefits

One of the areas in which credit cards can add a significant benefit is travel. Below are a few of the benefits the travel cards have that may be of use to you, but that you may not know about.

Travel Insurance — This insurance can include medical and dental coverage within certain limits if you’re traveling outside of a certain radius of your home.

Car Rental Insurance — It is important to know whether the insurance provided by the card is primary or secondary insurance. Primary insurance means the card’s insurance covers the incident up to the benefit amount without factoring in any existing auto insurance coverage you may have. Secondary insurance requires that your personal auto insurance policy pay any claim up to your personal auto insurance limit first, then the secondary insurance will cover the remainder up to the secondary insurance limit amount.

Access to Airplane Lounges — This can be access to a particular network or provider of lounges and will often include free showers, food, drinks, WIFI, and a quieter place in the airport to relax and wait for your flight. The airline-specific lounges may also be able to help you with any ticket changes without the need to wait in the normal check-in lines in the case of a canceled or delayed flight. This may also allow the card holder to bring a certain number of guests into the lounge for free or for an added charge.

Trip Cancellation Insurance — This insurance will give you a refund for any eligible non-refundable trip expenses if certain emergencies arise that mandate a trip cancellation.

Trip Interruption Insurance — This provides a stipend if your trip is delayed by a certain amount of time. For instance, the card may give a certain dollar amount credit per person on the trip if your flight is delayed by more than four or five hours. This credit can generally be used for lodging or dining.

Baggage Delay Insurance — This insurance provides a stipend if your baggage from a flight is delayed for a certain amount of time so that you have money to replace essential items while you wait for your bags to be delivered to your hotel or home.

Lost Luggage Reimbursement — This is similar to baggage delay insurance as it provides you with a certain amount of money if your bags are lost and never recovered. This is intended to allow you to replace the items in your baggage up to a certain dollar limit.

No Foreign Transaction Fees — This can be meaningful as some credit cards charge 1 to 3% in foreign transaction fees on any purchase paid for in a foreign currency; often, paying for things in U.S. dollars while in foreign countries comes with hidden expenses.

Credit for Global Entry or TSA Pre-Check Fee — This may be provided to cover the cost for the owner of the card to get Global Entry or TSA Pre-Check, both of which help in getting through airport lines much more quickly.

Accidental Death and Dismemberment Insurance — This provides for a certain amount of insurance if an accidental death or serious injury should occur while you are in transit paid for with the credit card. This amount can range from around $100,000 to $1,000,000 per person.

Emergency Evacuation and Transportation Insurance — This is used to help you leave a country you are visiting if there is a medical emergency, and may provide help ranging from special flight accommodations to being escorted by a doctor so that you can get medical care in your home country.

Special Arrangement with Travel Providers — This can include priority boarding, free checked bags on flights, frequent customer or preferred customer status with a travel company, free upgrades if available, free nights at hotels if you booked for a certain number of nights, free Internet access, resort credits, or free breakfast.

Other Benefits

Many credit cards come with a concierge service. Generally speaking, the low quality of help provided never ceases to amaze me regarding these services. That’s not to say that value cannot be derived by using these services, but the value varies greatly depending upon the request and the individual working for the concierge service assisting you. The best uses of these services, in my experience, tend to be along the lines of a very basic task-oriented personal assistant. It is unusual to be able to get any reservations or tickets from these services that you would not be able to get on your own. It can be very useful to call the service before leaving for vacation and ask for a city guide for the city that you are visiting to include things along the lines of best restaurants, entertainment, things to see, any special events happening in town while you are there, best hotels in town, or a list of available tours. The service can also be used to coordinate with companies in other countries that only have an international phone number so that you do not have to make an international call in order to do business with the company in the other country, for instance, buying a product or making a restaurant reservation.

Some credit cards arrange for special access or discounts on tickets for sporting, music, or entertainment events.

It has become more common for credit cards to provide you with access to your credit score so that you can monitor it for free on a regular basis.

Roadside assistance is a benefit that is often overlooked by those with credit cards that have the coverage and may be paying for roadside assistance unnecessarily.

Some of the higher-end credit cards also provide annual credits. These can be for any travel-related expenses, a particular named airline and the associated fees, or for some specific service such as Uber. These credits, if available, generally amount to hundreds of dollars per year. The way that these credits are given may also lead to some opportunities. Often, the credits are given on a calendar-year basis. This means that each January the credit resets. Membership fees, however, are usually charged on a membership-year basis, in other words, twelve months from the date you sign up for the card. This means you may be able to sign up for a credit card in June so the first year’s fee covers the timespan between June and December, get a new credit in January and use the new credit before June, then cancel the card having only paid for one year’s worth of membership but receiving two years’ worth of credits.

Special Considerations

Credit card fees can range from nothing to hundreds, or even thousands, of dollars per year. These fees may be worth paying if the benefits are substantial enough to justify the cost and in fact you may end up making a profit from owning a high-fee card if the card is a good choice for you and the way you use credit and the benefits involved. The signup bonus provided by the card may good be enough to justify the first few years of fees, regardless of any other benefits.

Credit Card Rewards

Credit card rewards and redemptions are a benefit that can add some of the highest value if used strategically. Often, it seems that credit card rewards schemes are built to be intentionally misleading or confusing which can cause people to get a far smaller return than that which is possible. This section could go very in-depth and certainly the more time someone spends understanding these rewards, the more they are able to get a good or very good return from the rewards that they have earned. The purpose of this section is not to teach you how to maximize rewards, as that is a constantly-changing field, but to help you at least get an acceptable level of return from the rewards you are earning. For our purposes, a 2% return is what should be expected as a minimum from your credit card purchases. The reason for this is that there are cards available that provide you with 2% cash back in every category with no yearly fees.

If you are not getting at least 2% back from your purchases, a cash back card may be the best card for you on a day-to-day spending basis. As a general rule, it is less beneficial to use rewards for products, cash back, or cheap airline tickets. An easy way to tell if you are getting at least 2% back is to look at the price of the airline ticket or other benefit you would be redeeming and compare it to the number of miles or points you must redeem to get the same ticket. Here is an example: let’s say you earn 1 point per dollar spent. The ticket you want to book is either $300 or 30,000 points. We would calculate your percentage return by dividing the $300 cost of the ticket by 30,000 points, which gives us 1%. Because you were only earning 1 point per dollar spent, you would multiply the 1 point per dollar spent by the 1% and get a final return on your reward of 1%. In this case, you would have earned twice as much money just by having a cash back reward card that gave you 2% cash back and you would be able to book any airline ticket or other benefit you wanted with the money earned from the cash back. In the case of an airline ticket, you would also have the benefit of earning frequent flyer miles on the airline for the miles flown during the flight.

It is not uncommon for me to see people receiving less than half of a percent back from their rewards. Keep in mind, there are some cards that will pay you multiple points for every dollar spent in certain categories. This means that if you earn 3 points per dollar spent in the situation mentioned above, you would multiply the 1% redemption by the 3 points per dollar spent to give you a 3% return. Returns can significantly exceed 2 or 3% if you are willing to spend the time to maximize them, but it will take some time and research in order to be able to learn to do so. The reason to perform the calculation is to know what you are actually getting in rewards so that you know if you should switch to a cash back card, that will not provide the most optimal rewards, but will provide ease of use and at least the minimum amount of rewards back, or if you should choose to learn more about rewards and how to maximize them.

One last point to mention on rewards is the Rewards Network. This is a service that is at the center of many airlines’ dining programs and Upromise college cash back. You can add any credit card to one of these services online, and if you dine at one of the participating restaurants, you earn either additional airline rewards or cash back for college savings automatically. These services are free and only require a one-time sign up on the program’s website, though you can only choose one of the programs for each card. You might be surprised at how often you dine at one of the participating restaurants and earn miles or dollars just for going through a one-time sign up.

The intent of this article is not to encourage the use of a particular card or type of card, but to make you aware of some of the lesser-known benefits of using a credit card. That being said, there are a few cards that are among my favorites, which include Fidelity Rewards Visa Signature, Citibank Double Cash, Citibank Prestige, Chase Sapphire Reserve, and American Express Platinum. If you fly often on the same airline and have checked luggage, it may also be worthwhile to have that airline’s credit card so that you can check bags for free and receive priority boarding. The yearly cost of the card may be more than made up for by the amount of money that would have otherwise been spent on checked baggage.

Feel free to contact Josh Mungavin CFP®, CRC® with any questions by phone 305.448.8882 ext. 219 or email: JMungavin@EK-FF.com.

False Security: When Stop Loss May Really Mean Guaranteed Loss

I was reading a story in one of my profession’s trade journals about a financial advisor’s solution to helping retired clients develop income strategies in a volatile market. The advisor has been in business since the early 1970s, but the 2008 financial crisis was his wake-up call to move to “tactical investing.”

I have to confess that I’m a skeptic about anyone’s ability to call market turns, so I was already biased when I started reading the article. But I lost it when the story said his major strategy was using stop-loss orders to avoid big declines.

For those not familiar with a stop-loss order, I’ll explain: it’s an instruction to your broker to put in a sell order if your stock price ever drops below a predetermined price.

To find out more about the dangers of this strategy, let’s eavesdrop on this advisor’s conversation with a customer.

 

Dr. Charles (Dr. C.): Hello, Joe [the broker]. This is Dr. Charles.

Broker: Dr. Charles, how can I protect your investments today?

Dr. C: I have a large investment in High Tech, Inc., after all, you recommended it to me.

B: A terrific investment recommendation, if I may say so myself.

Dr. C.: Well, yes, but the thing is I’m becoming a bit concerned about it.

B: Why? High Tech is the future.

Dr. C.: Maybe so, but the stock is bouncing around like a yo-yo. It’s finally back up over the high it reached eighteen months ago, but I’m afraid, given its history, it’s going to drop back down again on me.

B: Would you like me to protect you from your stock investments going down?

Dr. C.: Exactly! Would you?

B: Certainly. I’ve been practicing this safe investment methodology since, well—there really isn’t any reason to get into how recently I’ve changed my entire investment philosophy. The point is it looks as if you need a stop-loss order.

Dr. C.: A stop-loss order? Is that what it sounds like it is?

B: The point of a stop loss is to stop your losses and let you keep your gains. You like gains, don’t you?

Dr. C.: Yes. Yes, I do.

B: And what about losses?

Dr. C.: Not so much.

B: So let’s look at the old terminal here. I see that High Tech is trading at about $56½, which is a pretty nice run during the past couple of weeks.

Dr. C.: Right. But before that run, it was priced below what I paid for it.

B: It looks like the last trade was at $56. It’s been trading in a pretty narrow range, between $50 and $60, for the last few days.

Dr. C.: So what can I do to protect myself from the next drop?

B: Tell you what. I’ll put a stop loss in for you at $52. Your basis is $48 so, if worse comes to worst, you’ll lock in a profit of $4/share.

Dr. C.: Thank you, Joe. You’re the best. Now I can sleep at night.

[Nine months later]

Dr. C.: Hello, Joe.

B: Hello, Dr. Charles. How can I protect your investments today?

Dr. C.: Well, you may have noticed the screaming headlines in the newspapers or heard the cable television folks talking about the fact that the bottom dropped out of the tech market.

B: I did notice, yes.

Dr. C.: High Tech was clobbered worse than most. I just wanted to be sure my stop loss got executed.

B: Yes, sir, I see your position now. It did get traded.

Dr. C.: Thank goodness, I just saw it trading at $32! Sure am glad I got out at $48. With my 10,000 shares, I still made a nice profit of $40,000. Thanks, Joe. That’s all I wanted to find out.

B: Uh, hold on a minute. You’re correct that it’s now trading at $32.25. But when the initial sell-off hit, the stock actually dropped all the way down to $27.

Dr. C.: Now, I feel even better that I was able to sell out.

B: Well, that’s the thing. When your stock dropped below $48, that triggered your stop-loss order, all right. Then your shares were sold at market. Unfortunately, the price you sold at was $29.50 not $48.

Dr. C.: What?! How could you have sold me out at $29.5?! I said I wanted $48 minimum.

B: Well, I’m afraid that’s not how a stop-loss order works. I just assumed you knew that when we set it up. All a stop loss does is trigger an open-sell order when and if the stock price drops below the stop-loss price. What happened with High Tech is that with the huge volume of sell orders pouring in, a few trades were done at $48, resulting in your open order to sell “at market.” Unfortunately, there was already a ton of sell orders on the books ahead of you. So by the time your order was executed, the price was $29.50.

[One week later]

Dr. C.: Hello, Harold.

Harold Evensky (HE): Pardon me. Who is this?

Dr. C.: My name is Dr. Charles. I saw you were quoted in the Journal, and you had some skeptical things to say about stop-loss orders. I’m looking for a new financial advisor, and I was hoping you could tell me more about what you think of stop-loss strategies.

HE: On the surface, they look great. They cost nothing, and they preserve all the possibility of further gains, and if you don’t know how they work, you might think that they eliminate the potential of loss beyond the stop-loss order price. Unfortunately, that’s an illusion.

Dr. C.: Tell me more.

HE: The major problem with stop-loss orders is they’re executed mindlessly. There is no guarantee what price you’ll sell at once the stop-loss order is triggered. If the market’s falling rapidly, you may end up selling at a price well below your stop-loss price.

Dr. C.: Actually, I found that out the hard way.

HE: I’m sorry to hear that. But you’re not alone. Here’s a quote from John Gabriel, a Morningstar strategist:

One type of trade that we vehemently avoid more than any other is known as a “stop-loss” order. Consider yourself warned: if you perform an online search for this term, you’re likely to find some misleading definitions. For instance, you may come across an explanation like, “setting a stop-loss order for 10 percent below the price you paid for the security will limit your loss to 10 percent.” Our main problems with this statement are that it is blatantly false, imparts a false sense of security, and can lead to truly disastrous results.

 

Dr. C.: I wish I’d seen that a month ago.

HE: Gabriel went on to say, “We often quip that a more appropriate name for a stop-loss order would be a guaranteed-loss order”—strong stuff and I couldn’t agree more.

Dr. C.: Do you know of any strategy that does work to limit losses?

HE: You can somewhat mitigate the risk of selling way below your targeted stop-loss price by using what’s called a stop-loss limit order. It’s a little more complicated, but it tells your broker to enter a sell order if the price drops below the stop-loss, but also tells him not to sell if it falls below an even lower limit order. The catch is, if that happens, it means you still own the stock after the price has dropped.

Dr. C.: So, in other words, safety is an illusion.

HE: My bottom line is: If you decide to be a market maven and pick your own stock, then you should decide when to sell, depending on the market environment at the time. Don’t fall for the false security of a mindless automatic trigger. In fact, you may not want to sell at all.

Dr. C.: What do you mean?

HE: When you go to the grocery store and something goes on sale and the price is really cheap, does that mean you go home, rummage around your refrigerator, and offer to sell stuff back to the store at a price that is lower than you bought it?

Dr. C.: Of course, not. I’d probably take advantage of the low price and buy extra.

HE: Then why do people do just the opposite with stocks? When stocks go on sale, the first thing people think about is selling. To my way of thinking, a big drop in price may be a terrific opportunity to buy more, not a reason to sell.

Dr. C.: I never thought of that.

HE: If you want to come in and talk with me, I can set up an appointment. But I’m going to warn you in advance: I don’t have any magic formula for protecting you against the ups and downs of the stock market.

Dr. C.: Believe it or not, at the moment, that’s music to my ears.

This blog is a chapter from Harold Evensky’s “Hello Harold: A Veteran Financial Advisor Shares Stories to Help Make You Be a Better Investor”. Available for purchase on Amazon.