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Where should I set a stop-loss, if at all? I just never know when to sell.
It’s one of the most frequent questions I receive from our readers here at Wyatt Investment Research.
In fact, it’s a question that my fellow employees have been inquiring about lately. Once a month we meet as a company to discuss “all things investing” for our investment club, Kicking Assets. In our last meeting stop-losses were the hot topic.
Like any, our club has a wide range of investment philosophies. But there’s one thing we all agree on and that’s not losing money.
So I’ve decided to offer some food for thought that will hopefully spark a discussion not only with the members of our small club, but for you as well.
Before we made our first trade several years ago we decided on a few basic parameters. One of the more important decisions, at least from a risk management standpoint, was to maintain a consistent position-size among our holdings. We wanted to limit the havoc one stock could have on our portfolio.
We currently have 10 positions.
For simplicity’s sake let’s say the portfolio was worth $10,000. Ten positions, equally-weighted at $1,000.
So with ten stocks, a 10% drop in one stock will cause a 1% drop in our overall portfolio. A 20% drop will cause a 2% drop, 30% would be 3%…you get the picture. Just knowing the aforementioned gives every long-term investor the insight necessary to shape a stop-loss strategy for maximum effectiveness.
Let’s say we decide on a trailing stop of 30% at our next meeting. Let me pause for a moment to explain what I mean by “trailing”. If we buy a stock for $10 our stop-loss would immediately be set at $7. If the stock pushes steadily higher we “trail” our 30% stop-loss. So when a stock pushes 30% higher we end up with a “trailing” stop-loss of $10…basically break-even on the investment. Anything higher is money in our pockets.
Here’s another factor to consider. Worst case scenario, if we assume our position-size of $1000, and maximum loss of 30% for each stock, our maximum portfolio risk is $3000.
As you can see from the table above a 30% loss in the portfolio would need a 43% overall gain to make up for the loss. You can begin to see the importance of setting stop-losses when you consider it takes a 100% gain to make for a 50% loss.
I realize the prior exercise is fairly simplistic. Again, it only begins the important discussion of money-management. Without some form of money-management portfolios emotions take over. And emotions are the enemy. Hindsight never exists in the present. We must realize that we will be wrong on occasion. But we know over the long-term having a defined stop-loss will only serve to benefit the performance of our respective portfolios.
More importantly, we always know when to sell.
Of course, all the above assumes that our group prefers the straight percentage stop-loss. Please don’t. In my opinion, a volatility-based stop-loss is far more effective. Think about it, your typical blue-chip stock doesn’t carry the same risk as your standard small cap stock. So why would you set a standard stop-loss across the board?
Volatility-based stop losses are based on probabilities attached to an individual stock’s volatility. Straight percentage stop losses completely ignore this fact making them somewhat arbitrary. I’ll be discussing how I use volatility-based stop losses and other ways to manage risk, including beta-weighting a portfolio in The Strike Price over the next month.
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