One of the few, true secrets of successful speculation - trailing stop losses...

As longtime readers know, I write the Friday Digests personally. I do so because I believe every one of our subscribers should understand fully a few important ideas about finance. I hope if I write about these issues regularly, you will take the time to think about them. If you do, you will become a vastly better investor. And I know from the feedback I've gotten over many years, these ideas have transformed people's financial lives. They really work.

Today, I'd like to review the idea of trailing stop losses. Now, you say, "I've been using this strategy for years. I already know everything about it." You might think that's true… But in my experience, even sophisticated and experienced investors have a hard time using trailing stop losses accurately. It can be emotionally challenging to cut your losses and technically difficult. I have two solutions to share with you, today. (Don't worry… If you've never heard of stop losses before, I'll explain them thoroughly.)

More important… I commissioned (at considerable expense) a thorough study on the subject. You see, a fundamental debate is ongoing about using stop losses all together. Many smart and talented advisors regularly criticize our stop loss strategies – sometimes with great passion. But they cite only anecdotal evidence. In the past, we've responded with some statistical proof… but nothing bulletproof. I've often wondered if our preference for limiting risk was as effective as we believed. And so I decided to settle the matter once and for all…

I hired one of the world's best statistical analysts to analyze the track record of our best fundamental advisory, Extreme Value. The purpose of the analysis was to answer this question: Does the use of trailing stop losses improve investment performance?

You'll get the whole story below…

But before we get to the detailed analysis… some new readers probably don't know exactly what a trailing stop loss is or how to use it appropriately. What the heck is a trailing stop loss? A stop loss is the price at which you will sell a stock, no matter what else is going on in the market. If you buy a stock at $10 and decide to strictly limit your risk to 25% of your investment, you will sell that stock if it trades for less than $7.50. Selling is the only way to guarantee your loss won't grow. Critics of this approach argue it's illogical to decide (in advance) to sell only when doing so ensures a loss.

A trailing stop loss takes on this criticism by increasing your automatic sell point if the stock moves higher. So if you buy the stock at $10, your initial 25% trailing stop would be set at $7.50. But if the stock eventually traded as high as $15 a share, you would move your stop to $11.25. This way, you're not necessarily going to take a loss at all… even if you're forced to exit the position because of your stop. Your stop loss point is said to "trail" the stock price higher, which is why it's called a "trailing stop loss."

Steve Sjuggerud was one of the real pioneers of this technique. He used this approach during his time as a broker – mostly to keep clients from continuing to dump money into losing positions. Van Tharp is another pioneer of the strategy. He profiled it in his extremely profitable book, Trade Your Way to Financial Freedom.

When I began working with Steve 15 years ago, few individual investors used stops of any kind. Brokerage firms didn't offer them much in the way of support. Today, most individual investors understand trailing stops and most brokerage firms offer the ability to use them on their electronic platforms. But we strongly recommend you should ALWAYS keep your trailing stop loss levels completely private and never share them with your broker.

Why? Because many times your broker will enter your stop loss in the market on a good-until-canceled basis. That means other traders can see where your stop is set. If the market gets close to that point and lots of investors have set stops at about the same price, the market makers will move the market to trigger those stops, knowing once the selling is done, the price will quickly rebound. We have seen the market makers do this to many of our recommendations over the years. Never enter your stops with your broker. NEVER.

But how are you supposed to follow your stops if your broker doesn't monitor your positions for you? Well, one easy way is to use www.tradestops.com. This website allows you to enter your stocks and set a percentage stop loss. The website will notify you – privately – if your stock has been stopped out, allowing you to exit the position.

The website is the brainchild of Dr. Richard Smith – a longtime subscriber and a good friend to our business. Dr. Smith has a Ph.D. in mathematical systems. He is one of the smartest and most talented people we know. He regularly helps us when we need advanced computer programming or intense statistical analysis – like when we were building our True Wealth Systems models. I don't get paid a penny for saying this, I simply know it's true: If you use www.tradestops.com, you will make more money with your investments.

How do I know it's true? How can I really know that using trailing stop losses will improve your investment performance?

First, it's logical. Using a stop loss will not optimize any individual position. It will not help you buy at the bottom or sell at the top. (Of course, nothing but experience and knowledge can help you with this goal. There's no short cut.) But using stop losses does allow you to systematically structure the risk you're willing to accept. And by limiting your risk, you will certainly improve the overall performance of your portfolio. Why? Because using stop losses completely prevents the catastrophic losses that end up destroying your portfolio's long-term performance.

I've seen lots of newsletter writers do a good job for their readers… until they pick the wrong stock at the wrong time and it blows up. It goes to zero… or nearly zero. They suffer a 90% loss. That one loss ends up wiping out dozens of successful investments. And I know this happens, time after time, to individual investors. Using stops on all your positions will make this impossible. And your results will greatly improve.

Most people can grasp this concept. And most people realize the strategy makes sense based on their investing histories. But… most people have a difficult time following the strategy and making it an automatic part of their investing. Instead, they put a "mental" stop on their positions. When it is triggered… they do nothing.

They convince themselves not to sell yet… that the stock will soon bounce back. They wait. And wait. And pretty soon they're down 90% on a stock and right back to where they started.

I commissioned Dr. Richard Smith to look at every recommendation published in Extreme Value since its inception in 2002. This eight-year track record gave us a valuable and unique laboratory in which to test our hypothesis that using trailing stop losses greatly increases investment performance.

Why? Two reasons. First, Dan Ferris does not use trailing stop losses in Extreme Value (except with shorts). Dan firmly believes the best approach to risk management is to always buy good companies at a low enough price to ensure a "margin of safety." Using this record, we can go back and see if an investor, who had used trailing stop losses, would he have made more money than simply following Dan's advice on when to sell.

The other consideration is the quality of the letter. Maybe stop losses do work when you're using a lousy investor's recommendations, but what if you're following a great investor like Dan? We charge $1,000 a year for Extreme Value. It's widely read by the world's best hedge funds. It's highly respected on Wall Street because of its unique focus on value, safety, and quality. It has a great track record. Trailing stops should not be effective in this portfolio.

What did Dr. Richard Smith find? Over the last eight years, we've recommended 82 separate equities in Extreme Value. Keep in mind… a handful of these positions were short sell recommendations. The average gain across every recommendation made from 2002 through 2010 was 15.06%. That's a terrific result given the dominant market movement in the period was the terrible bear market of 2008. The average duration of these investments was 605 days. This implies an average annual return of 8.79%. We are extremely proud of these results, which outclass just about any equity mutual fund, and we know how hard Dan worked to achieve them…

But we always strive for better results. Always. Is using trailing stop losses a simple, mechanical way to improve our performance?

The answer is undeniable: YES. Dr. Richard Smith put Dan's performance data into a statistical database that allows us to compare the results of using trailing stops at various levels. In this way, we could discover if using "tight" trailing stops (say at 10% or 12%) worked better than using loose trailing stops (say 30% or 50%). Here's what we found…

Using tight trailing stop losses greatly reduced performance, in almost a uniform way. The average profit of all the trailing stops at or below 15% reduced performance. The greatest reductions occurred at the lowest stop levels. If your stops are too tight, you will do worse than not using any stops at all.

Using trailing stops of 16% or higher increased performance, almost uniformly, all the way up to a trailing stop level of 34%. That is, using trailing stops at any level between 16% and 34% increased performance, with the best performance coming at the highest level.

The average gain using a trailing stop at 34% was 31%. The average duration was 433 days. The average annual result of this portfolio would have been 25.5%, or nearly three times the actual performance of Extreme Value. This represents a large and statistically meaningful increase in performance. There's almost no way this difference is merely chance.

Performance begins to decline, using trailing stops larger than 34%. The duration of the investments is increasing while the average gain is decreasing.

These results suggest the most effective trailing stop level for Extreme Value is somewhere between 27% and 34%. Using trailing stops at these levels doubled the average returns of Dan's letter, while reducing the average time period by roughly a third.

Looking at these results, I want to reiterate in the strongest possible terms that you should be using trailing stop losses. And you might rightfully wonder… did seeing these results change Dan's opinion about using trailing stops? Maybe.

He told me he would consider it carefully. As for me, I hope Dan won't change a thing about his approach. Why not? I think some analysts sometimes use trailing stops as a crutch… or a safety net. I like that Dan is up on the wire, all alone, without any tools or tricks to help him. I want him to do all the hard work without any help... I believe that's the way we all can get the most out of him. But I'd use his ideas with trailing stops… just in case.

New highs: Continental Minerals (KMK.V), China MediaExpress Holdings (CCME), CARBO Ceramics (CRR), ExxonMobil (XOM), Wal-Mart (WMT).

Once again, we don't dislike America, just its politicians. feedback@stansberryresearch.com.

"You have such a dislike for this country [because of the] remarks you make and the names you call our President. [Also] telling us how to move our money out of the country or even move ourselves out. I wonder what country you made your millions in? I am 86 years old and still paying for investment advice, you are a young man and selling it! So I know you are very smart! Will you tell me an old man what country you made all that money in!" – Paid-up subscriber Ray Boatman

Porter comment: Well... I don't think that calling the president names means I hate my country. Seems to me hating political leaders is what this country was founded on... and what it has had a rich tradition of doing ever since. As for protecting my money and trying to get my subscribers to do the same... I'll ask you a question in response...

Imagine for just a moment that we actually know what we're talking about when it comes to finance and economics... and imagine for just a moment that we're probably right when we say the U.S.'s debts, which total almost $700,000 per American family, aren't affordable and won't be paid back.

Assume – just for a moment – we're right. What would you rather have in America? A citizenry that's totally invested in the bonds of its bankrupt government? Or a citizenry that has safely stored its wealth in things like gold, silver, and foreign real estate that's nearly impossible to steal?

The point I'm making is… there's a big difference between loving your country (and your countrymen) and admiring the idiotic policies of your government. Likewise, there's a huge difference between a good (and wise) citizen, and someone who believes the lies they're told by the president.

"My name is Sandy Woosley. After listening to your End of America video, I was so overcome & distressed I couldn't sleep. I tried to join your membership with my charge card but seem to have trouble with it at this time… I do like to hear what to do in this crisis time but your stock information is way over my head financially & I really don't understand the market.

"I live from paycheck to paycheck as many Americans these days and was trying to make a little money to help in this crisis but everything is for the rich and if I looked at anything that was continued there was another thing to sign up for, at one point I thought I was registering for the same product 3 or 4 times... very confusing. I think the only one which was to be helpfull was the Daily Wealth issue since he did say even a beginner could take $50 & invest but I never found out how to start from the beginning. I just went on to another page to sign up for something else. Please help me... Thanks..." – Paid-up subscriber Sandy

Porter comment: I must admit... We are in business to make rich people richer. Why? Because that's where the money is, of course.

But... we published "The End of America" – against the better judgment of many in our business – because we care deeply about our country and the fate of so many people like you.

We offer two completely free advisories: DailyWealth and GrowthStock Wire. We also offer a handful of low-cost investment newsletters. See our website for more details on these.

I believe many of the things we've warned about and the suggestions we've made to protect you don't require any substantial wealth. They just require understanding and planning. Good luck.

"Having lived in Illinois my entire life, the people of this state continue to floor me. I don't understand why we keep voting in these pro union high taxation crooked politicians and expect anything to change in a positive way. The latest is this ridiculous idea that we are going to tax our way into the green. My wife and I sell real estate in the Chicago suburbs and people are wanting to move out as fast as they can. We speak to business owners alike and many are making plans to move to neighboring states. Real Estate values statewide were down another 7-8% last year and 28 to 35% since the downturn. This latest so-called solution I feel is just going to make matters worse. Being in our fifties my wife and I would be out of here in a heartbeat if our business was not here." – Paid-up subscriber Don Doherty

Porter comment: Chicago… the new Detroit.

"Could you please add me back to your S&A Digest? Oddly, I have seemed to have dropped off your distribution. The S&A Digest has already been added to my Address Contact list. Thanks in advance for your assistance." – Paid-up subscriber Michael Prinzivalli

Porter comment: Michael, bless you. I can't recall the last time I opened a note that didn't say exactly the opposite.

"Thank you for the personal response. Please do not lose heart if others cannot appreciate the quality of S&A's work. S&A's work product is a breath of fresh air, in my humble opinion. Let me tell you that I do not make that statement lightly. I can say that because I work as a Credit Trader/Analyst for a life insurance company. I have read Moody's, S&P, Fitch, DBRS, CreditSights, and just about every conceivable piece of street research published. Keep up the good work." – Paid-up subscriber Michael Prinzivalli

Regards,

Porter Stansberry
Baltimore, Maryland
January 28, 2011

P.S. There are two important ideas from last year I hope you'll take the time to review. I've explained why certain corporate bonds are the best and safest way to invest. (To learn more about our bond service, click here). I've also explained why selling puts is one of the true secrets of Wall Street and one of the only ways to get rich in the stock market without taking any real risk – or even buying stocks at all. (To learn more about the advisory that emphasizes put selling, click here.)