Sunday, July 24, 2016

Why stop losses are a key to stock market success

I have written quite a bit about becoming wealthy via investing and speculating in the capital markets. Doing research and picking the right security is definitely a big part of the equation. Timing is also a big factor. One must buy the correct security at the correct time and at the correct price. I would go as far to argue that the price you pay for a stock determines how much you will profit, if at all.

These skills are all subjective in that although we can use data and history to help guide our decisions we cannot know the outcome of any of trades beforehand. We can increase our odds of success but we will still not have certainty.

Two of the things that we can control about our investments that are certain are position sizing and stop losses. These are two items related to an investment that most people give very little thought or attention to.

A stop loss is very important because large drawdowns in your account are very difficult to recover from. I define a drawdown as:

 "the peak-to-trough decline during a specific recorded period of an investment, fund or commodity. A drawdown is usually quoted as the percentage between the peak and the subsequent trough."

Lets say we have a $1000 stock investment account and we buy 100 shares of XYZ corp. stock for $10 per share. Assume the stock drops to $7.50 per share which is a loss of 25%. What percentage gain do we now need to get back to even amount of $1000?  The math says we need a 33% increase in XYZ corp. just to get back to even.

How about a 50% loss? You would need a gain of 100% just to get back to even. A 90% loss, which I am embarrassed to say I have taken in the recent past would require a whopping 1000% gain just to get back to even.

Ask yourself how many 1000% winners you have had in your investing career. How many 100% winners? These type of gains just do not happen that often in an investing career. In order to have success one must cut losses early and let winners run.

I have failed many time in this endeavor mostly because of ego. You put alot of work and time into researching an idea and then you pull the trigger and the stock goes down. It may go down even though the prospects of the company do not change. Or you just might be wrong in your analysis.

However, instead of taking a loss a loss and living to fight another day we hold and then begin to rationalize that the stock will go back up. This is the kiss of death to investment returns and is one of the main reasons individual investors (you and me) suck at beating the averages. 

A recent study by the Boston-based financial-research firm Dalbar found that the average investor in all U.S. stock funds earned 3.7% annually over the past 30 years, while the S&P 500 stock index had an annual return of 11.1%. In other words, the market outperformed stock-fund investors by about 7.4% annually over three decades.

We have to control this urge to hold on. You are a long term investor until you are down 90% and then you sell at the bottom. It happens over and over to individual investors. What I have done is to try and automate the stop loss process. I use Tradestops. This software program allows you to enter your stocks, the date bought, price paid, number of shares. You also enter the percentage loss you are willing to take. For a larger more blue chip investment I like to use 25%. For my more speculative picks like junior mining stocks I like to use a 50% stoploss as these smaller stocks are more volatile.

Tradestops looks at your portfolio everyday and then if the stock drops by the determined percent you specified you get an email notifying you. You then should take action and sell the stock. No questions asked and regardless of the blow to your ego. Think of like being a professional baseball player and hitting. Even the very best hitters never get a hit much moire than 3 in 10 times at bat. Yet if you were to hit for that type of average in the majors you would be a star.

This software that Tradestops offers takes some of the emotion out of the investing equation. You get the email and then you act. It becomes a sterile, mechanical operation. You can always reassess and buy back in at a later date if you look at the stock later and then decide the situation warrants. You just cannot afford to take 50-90% losses and be successful long term.

The other good feature of the software is that as the price rises the software automatically raises the stoploss price up along with the share price. This saves you time and effort as you don't have to do all kinds of calculations on a daily or weekly basis. The software also will account for any dividends paid on the stock and lower you cost basis on a stock by the amount of the dividend paid.

I saw many guys I worked with let million dollar portfolios go down 90% in the dot com bust and they never recovered. Some are still waiting to get back to even or sold out at the bottom for a total loss. I have taken big losses in my own career and I need to cull the current portfolio of some wounded ducks. It happens because of ego and emotion. Don't let it happen to you consider using Tradestops software for your portfolio.

There is a cost to Tradestops (I get no compensation from recommending this product) and I believe it is around $100 or so dollars per year. However I consider it money well spent. We are not going to be right all the time in our stock selections. But if we cut our losses early and take as much emotion out of the process as possible you become wealthy by being correct in your stock selections even less than 50% of the time.

Cut your losses early and let your winners run

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