Blog: Cut your losses
Investors know (or should know) that in order to make money in the markets you have to let your profits run and cut your losses short. It all makes sense. Doing it, however, is hard for most people. When I take on new clients we usually start out with a portfolio review and discuss the “corpses in the closet” the stocks that fell a significant amount and that the investor is still holding hoping for a turnaround. After all, he or she is a serious long term investor and in the long term the stock will be all right. Maybe, maybe not.
I believe it is paramount to have a set stop loss limit and sell the stock once this limit is reached, no matter what. I like to set my stop loss limit at around 8 % from entry on a close only basis. That means if the share price closes 8 % or more below my entry price on a single day I sell the stock the next day at market on average losing 8 %, sometimes more, sometimes a bit less. If I am down 8 % I need an 8.7 % return to make up my loss. This is not too hard and relatively easily achievable with another share selection. If I don’t have a stop loss and let the losses run, hoping for the best, the stats worsen exponentially. A 20 % loss requires a 25 % return to break even; a 50 % loss requires a 100 % return to break even. If I am still holding Slater & Gordon with a 97 % loss from the highest close ($ 7.85 on 2/4/15) I need a return of 3140 %to break even, possible but highly unlikely.
An 8 % stop loss however does not make sense if I have a significant unrealised profit on my position. If I am up let’s say 100 % it simply does not make sense to wait until the stock gives up all the unrealised profit and triggers the 8 % loss limit. We have to take profits if we give back too much open, i.e. unrealised profit. Too much usually means in average volatility stocks a retracement of around 20 % from the highest close. So if I bought at let’s say $ 50 and the stock runs up to $ 100 and then drops 20 % from the highest close to $ 80 I would take profits.
This stop loss limit is not perfect. Sometimes the stop loss is triggered, I get out because I am disciplined and then the stock has the audacity to go back up again (without me) and in hindsight I should not have sold. This will occasionally happen, probably just to lure us into not being disciplined and following our rules. But this is just the price to pay in investing. I should have no problems buyng the stock again (even at a higher price) if subsequent buy signals are triggered. A stock does not owe me any money and in the big scheme of things it does not matter if I make money in one company or another. It’s all the same money.
If the investor consistently applies above rules he should never be in a position where he lost a huge percentage of his capital. Being down 97 % as in Slater & Gordon right now simply would not happen.
Slater & Gordon looked like a great stock with good profit potential until we saw a series of distribution days. Distribution days happen on increased volume when the market opens
near the high of the day and closes near the low of the day. In the chart below these distribution days are marked with a red bar. We had 6 distribution days in a row warning the investor to get out and take profits. At the next circled price bars we can see a gap down on huge volume. Negative news hits the market and savvy investors run to the doors dumping stock to get out. This would be a very severe warning sign and at the very least we should have sold at that stage. This would have been way below our 20 % of highest close trailing stop and we would have retraced 33 % from the highest close but we would still have recovered some money. The last chance to get out with some dignity left would be on the last circle on even higher volume. This would have been too late for my liking but better than holding shares at current price levels with the possibility that SGH goes bankrupt.
Slater & Gordon, above