|
Category:
Insurance
News /
Investments /
Ashburton
/ February 2007
Stop Loss Strategy
Tilting the odds in your favour
“Cut your losers early and let your
winners run”. Sounds obvious, doesn’t it? Yet for many investors
this maxim does not form part of their investment strategy and, as
an active investment manager, I have always found this omission
puzzling.
 A
professional investor will ordinarily spend a great deal of time
deciding which stocks to buy for a portfolio. Typically, he will
consider such things as: the fundamentals of the business; whether
the stock is cheap or expensive relative to its peers; the health of
the industry, sector and economy; the breadth of the markets; the
timing of the purchase. At the end of this selection process, he
will have a stock he likes and perhaps a target price he expects
that stock to achieve.
Yet it seems many investors spend
little or no time preparing a contingency plan in case the stock
does not go up as they expect. To my mind this is perhaps the first
question you should ask yourself; ‘What happens if I’m wrong?’,
because with the best will in the world, no one can be right all of
the time.
Of course this is not a question
anybody really likes to ask themselves and this reticence has been
identified as one of the reasons why markets are not as efficient as
theorists would have you believe.
A new branch of study has become
increasingly influential in recent years, as market practitioners
have attempted to explain why markets can and do remain irrational
for long periods of time, the study of Investor Psychology.
Research in this field has identified many common mistakes investors
make when managing their portfolios. Two of the most common are
‘fear of regret’ and ‘seeking of pride’.
‘Fear of regret’ can be defined as the
reluctance to sell a losing position until it returns to somewhere
near the price originally paid for it. Say you buy a stock at £10,
but a few weeks later the price has fallen to £7. The temptation is
to hold on in the hope that the shares will at some stage recover,
whilst looking upon the missing £3 as ‘only a paper loss’. The
truth of the matter is, the markets are probably telling you
something important: it is a bad stock.
‘Seeking of pride’ is pretty much the
opposite. In this scenario, you buy the stock at £10, it goes up to
£12, whereupon you immediately sell it and tell your friends about
the cool 20% you made in a week, right? Wrong. If the stock goes
up 20%, the market is probably telling you that something has
fundamentally changed with the business. It is unlikely that the
stock price will reverse in the short-term, and the weight of
probability suggests more upside.
It is quite understandable that an
investor can fall into either of these traps, we are all human
beings after all. However, I believe it is vitally important to the
successful management of any portfolio that an investor rids himself
of emotional ties to his stocks and, instead adopts a rigorous
methodology to manage downside risk. So, how do you achieve this?
By using a ‘stop loss and stop loss of profit' strategy.
Going back to my earlier example, our
investor has just bought stock at £10. What he should do
immediately is set himself a price below which he would resolve to
sell the stock. If our investor decides he is prepared to lose a
maximum of 10%, then the stop loss price will be £9.00. If the
price falls below £9.00, he will sell.
Alternatively, let us assume that the
second scenario plays out, and the stock rises to £12. Instead of
selling and taking profits, our investor holds the stock. What he
should do now is adjust the price that would trigger a sale. If he
decides to keep the 10% downside risk protection, his stop loss of
profit would now be £10.80. He will continue to hold the stock as
long as it keeps going up, and will continue to raise the safety net
price, effectively ratcheting up the returns on the investment.
Clearly this is a simplified
description of the process, and there are various other inputs that
would ordinarily be factored into the decision, for example:
-
For an equity with a higher beta
(i.e. with more volatility of returns than the market), you
should consider allowing more latitude with the price action.
This will stop you from being ‘whipsawed’ out of a position,
that is to say, selling when your stop loss is breached without
allowing for the fact that the general trend in the stocks price
is still up, despite its wild price movements.
-
The more uncertain you are about
market conditions generally, the tighter your stops should be.
This allows you to factor in any macroeconomic ‘top down’
concerns you may have. Remember that in a general market
downturn, even the best stocks will go down.
Some professional investors use
‘technical analysis’, to decide important price levels that should
act as support for the stock price. Technical analysis, in its
simplest form, works on the premise that a price chart provides a
graphical illustration of investor psychology, and practitioners of
this craft will typically use lines drawn on charts to set their
stop loss points.
Fundamental investors contend that it
is impossible to predict future price movements from historical
charts in an efficient market and have rubbished this type of
investment strategy. But, whilst admittedly the process does use a
certain amount of artistic licence in determining important price
levels, irrational investors do exist, and you do see prices tend to
be ‘sticky’ at certain levels.
Perhaps then, the canny investor should
use both methods to achieve the best results, fundamental analysis
to choose the best stocks, and technical analysis to time entry and
exit points from the market.
One final observation I would make is
that the stop loss and stop loss of profit strategy will not be
successful all of the time. There will be times when a stock that
you have just cut proceeds to go flying up past its previous highs,
to your utter despair.
But take heart, by being rigorous in
your method and by systematically managing your portfolio to limit
downside risk, you will tilt the odds of success in your favour and
in the final analysis, that is the difference between success and
failure.
Ian Leverington, CFA Assistant
Investment Manager, Ashburton Bespoke Portfolio Service
Source: ITInews – Insurance
Times and Investments Online
www.itinews.co.za
 |
