Saturday, January 24, 2009

How to lose less with a Stop-Loss

"More money has probably been lost by investors holding a stock they really did not want until they could 'at least come out even' than from any other single reason", Philip A. Fisher.

You should re-read the quote above. If you have been investing in the stock market for any length of time, you have surely succumbed to the 'coming out even' fallacy at least once. If you are like me, you've probably done it more than once!

Truth is, Mr. Market does not know at what price you bought a stock or fund. Nor does he care. But you do, and that is the root of the problem.

I'm presuming that you performed due diligence in selecting a particular stock or a fund - carefully studying past performance, dividend records, peer comparisons. And yet, in spite of your best efforts, you pick a loser. It happens. All a part of the game.

This is when your investing mettle will be tested. Will you swallow your pride and get out? Will you soldier on, 'knowing' that you've picked a winner that will surely make you rich soon? Or will you become a 'long term investor' simply because your short term plans have got nixed?

A neat little device, called a 'Stop-Loss' level, may save you the blushes. How does it work? Before you buy a stock or a fund, you should decide how much loss you'll be able to tolerate. For an expensive stock, your loss tolerance may be less. For a cheaper fund it may be more.

As a conservative, long term investor, I like to set a stop-loss level of between 15% and 30% of the buy price.

Let us say I'm planning to buy a stock for Rs. 100, and set the stop-loss at 20%. If the stock falls to Rs. 80 or below, I'll not wait and sell immediately - thus stopping my loss at Rs. 20 per share.

What if the stock price rises to Rs. 120? Do I have a huge grin on my face and brag about my stock-picking skills to all and sundry? I'll be lying if I said, 'No'. But what I also do, is set a 'trailing stop-loss'.

What's that? It means increasing the original stop loss level by the same percentage as the rise in the stock's or fund's price. In our example, we will raise the stop-loss level to Rs. (120 - 24 =) 96.

If the stock moves up to Rs.200 (this happens usually in bull markets - but also some times in sharp bear market rallies), the stop-loss level will now be Rs.160.

Stop-loss levels not only help you to limit your losses, but a trailing stop-loss will protect your profits as well. Should the stock price suddenly fall to Rs. 150, your stop-loss level will be 'triggered' and you will sell off, pocketing the Rs. 50 per share (that you bought originally at Rs. 100).

The foregoing discussion has been written from the point-of-view of a conservative long-term investor. I have nothing against those who trade stocks on a daily basis, but I do not recommend trading to new investors.

But if trading is what gets you excited, you may want to read this article that provides more information and strategies for setting 'tighter' stop-losses for trading.

In the current bear market, the Sensex fell more than 60% from its January 2008 top of 21200. But many small investors are facing much bigger losses because of their penchant for buying smaller and cheaper stocks and funds.

The two lessons from such a traumatic experience are:

(1) most stocks or funds that seem a bargain are not; better stick to proven performers and market leaders;

(2) even if you've chosen the wrong stock or fund, applying a disciplined stop-loss mechanism will limit the losses.


Akash Sethia said...

Nicely written piece and makes a lot of sense. I am a new investor but have already tasted perils of sticking to something for too long.

Subhankar said...

There are many advantages in holding a stock for a long period, Aks. Specially if you have done your home work in choosing it.

If you can then apply the discipline of setting a trailing stop loss and practice the art of partial profit booking, then you will be on your way to building long term wealth.

Rishi said...

Dear Subhankarji,

Do you strictly follow the stop-loss for a core portfolio stock while picking up at a bottom?
Say a fundamentally good Large Cap Stock X is available at 150 during a bear market rally and the stock is purchased with a stop-loss set to 20%. Further the price came down to 120 - implying 20% loss, the stop-loss is triggered and share is sold. After some time the stock goes up to say 150 again? What would be the strategy here?
Instead if the stock goes to 100, what should be done?


Subhankar said...

Good question, Rishi.

If I'm adding to a core portfolio stock, then I don't apply a stop-loss because I know the stock inside and out. If it goes down after purchase, I buy some more.

But if I'm investing in a stock for the first time, then I apply the 15-30% stop-loss and get out if the stop-loss is triggered. If the stock goes down further, I do nothing. Once the stock starts to move up again, I may re-enter depending on technical analysis.

Remember that every investor should follow a plan that works for him.