Even with the market setting new highs day after day, we haven't really seen the kind of celebratory mood that should come with such record-breaking performances.
Don't get me wrong, it's great to see stocks rallying. In the past 12 months alone, defying skeptics, the S&P 500 index added some 18.7%, including dividends. The S&P's annual return is impressive, but it's still lagging behind the Nasdaq Composite's 29%, and the blue-chip Dow Industrials, which returned 22% the past year. And this is on top of an already-strong showing, which became the second-longest bull market on record as of last May.
Still, judging by the emails I've been getting, many investors are nervous.
It's not surprising that the memory of the last bear market is still fresh in the minds of many investors. After all, it's only been eight years since the S&P 500 bottomed (along with many retirement accounts). And that crash came soon after the dot-com crash at the turn of the century. The investors who needed that money the most -- recent retirees and those who were about to retire -- suffered immensely through these two downturns.
It's quite possible that the stress of these two bear markets will still be remembered many years from now. And as the market hits new records, the need to preserve hard-earned gains is quite understandable and rational.
The Best Wealth-Preservation Move You Can Make Right Now
Of course, I cannot possibly address all the questions related to the ways and methods of asset preservation -- not in a single issue, anyway. But rest assured, safety is something I always keep in mind.
With this in mind, I'd like to turn to a question asked by one of my Daily Paycheck premium subscribers concerned about the possibility of something significant happening in the market. In particular, this person asked about the use of stop-loss protection as a means to safeguard our portfolio.
A stop-loss is a tool some investors traditionally use to lock in a gain or to protect from further losses in a security. It's a trading order to sell a security when it hits a predetermined price. A trailing stop-loss order is different from a simple stop-loss in that the sell price is set at a certain percentage or a certain dollar amount below the market price.
This looks good in theory. Setting a stop-loss at a certain percentage seems to be taking the guesswork out of investing while protecting the portfolio at the same time.
But the devil is in the details.
If you decide to use a stop-loss order, it's up to you to decide the size of the decline that would trigger a sell order. Set it too large, and you may be forced to take a loss you never intended to. Set it too small, and you might be kicked out of the position even within normal trading bands or when market volatility accelerates.
This is especially true for smaller-cap stocks or for ETFs and closed-end funds, so exercise caution if and when you decide to use this strategy for such funds.
A Cautionary Tale For Stop-Loss Users
You might remember a strange trading day that happened a little less than two years ago, on August 24, 2015. In what is now known as the "flash crash," the Dow Industrials dropped some 1,100 points in the first five minutes of trading. That's big, considering that the Dow closed at 16,460 that day.
But for some ETFs and CEFs, the story on that day was worse.
Our portfolio's Eaton Vance Limited Duration Income Fund (NYSE: EVV), for one, dropped 16.7% in the first few minutes before rebounding to recover most of these losses. Any holders of EVV with a stop-loss in place of, say, 10% -- or even 15% -- likely would have been kicked out of the position before the recovery.
This is why you have to understand your investment before you set out to determine where you set your stop-loss order. The smaller the fund or stock, for instance, the worse the daily volatility can get.
And remember that a flash crash isn't the only event that can distort prices enough to trigger a stop-loss. Any volatility, or a "gap" in a stock price, can trigger it. And there's no guarantee that the execution price will be the price you want. Rather, once a stop loss is triggered, your stock will be sold at the next market price -- which can potentially be significantly lower than what you had in mind.
You might think these are one-off events, and that the benefits of creating portfolio protection via putting stop-loss orders in place outweigh the risks. And you may be right. But remember: we have been blessed with low market volatility lately, and when volatility picks up, so will daily price swings, which will inevitably change the price-loss projections. What might be right for the current market will become wrong for the more volatile one. Please act accordingly.
What This Means For Your Portfolio
Of course, the market doesn't have to go to the extremes, and investors may decide that they want to buy back a favorite long-term holding from which they've been stopped out. But remember this: If your primary goal is income, simply buying back a position might not be enough to get a fully beneficial treatment of dividends; you have to adhere to some strict holding period rules to qualify for a favorable treatment of a dividend.
Besides, there is still the question of what to do next. None of us knows whether a market decline of, say, 10% is the beginning of the next bear market or a simple downturn within the ongoing bull market. So I caution you to be careful with stop-loss orders, and don't use them as your main investment tool.
Nevertheless, if using stop-loss protection will let you sleep better, and allows you to enjoy your life rather than watching the market and worrying all the time, it could be the tool for you.
Either way, I believe that our Daily Paycheck portfolio is well positioned for the many challenges of this market. Together, we will gradually adjust the positions as needed, including building more protection against a potential market decline.
Because one of the best and time-tested protections against harder times is quality, in this issue I am improving our portfolio protection by adding a high-quality security to the Fast-Dividend Growers portfolio. It's cash-rich and an industry leader. And if it lives to its full potential, it should greatly reward its investors.
In any case, I believe it will be a great core holding, and I'm glad we are getting an opportunity to buy it at a relatively bargain price. It'll make a great addition to our portfolio, and will bring even more returns to my subscribers, some of whom are already earning an extra $1,543, $2,184, or even $4,200 cash each month.
It's "idiot-proof" investing that proves everyday investors can beat Wall Street at their own game. Click here for my special report that shows you how to get started.
This article originally appeared on Street Authority.