Investing
Cutting Your Losses
Taking a loss doesn't necessarily mean losing money, if you plan carefully and know when to sell.
FROM:
JUL-AUG 2003 ISSUE | BY
LARRY SHORT
The most perplexing decision for most investors is when to sell. It doesn't help that a plethora of reports and recommendations advocate that you should always buy. In fact, there are often more buy reports when the markets are high than when they are low, which goes against the basic investing mantra: buy low and sell high. Plus, with individual stocks, the downgrade from buy to sell usually takes place only after the stock has already fallen.
The disparate jargon many firms use in ranking stocks adds to the confusion. For example, one firm could rank a particular stock as a "strong buy," a "buy," a "hold" or a "sell." Another firm could categorize the exact same stock as an "outperform," a "market perform," a "neutral" or an "underperform." How do you make comparisons between firms?
Is the reason there are rarely any sell reports because you should never sell? Or is there some way to develop a sell discipline that will garner profits?
Stopping Losses
The perception that there are no blue chip stocks left seems to have rung true since the start of this century. Shares in large and supposedly stable corporations that were once the bastions of industry have fallen unexpectedly and drastically in price. Some of these companies had carried high bond ratings just before their collapse, which usually supported their blue chip aura. There should be some means to protect your investment in organizations like these, or at least minimize your losses.
There is: a tool called a stop-loss order, which is a sell order placed on a specific stock that is enacted when the stock falls below a given price. The
stop-loss order can remain open for weeks, but is automatically triggered if the price of the stock falls to a certain level. The client and investment adviser would agree on this price before placing the order.
For example, if you buy a stock at $20 per share, you can enter a
stop-loss order at the same time at $18.50. If, over the next few weeks, the stock falls in price and trades at or below the $18.50 level, it will be sold. By using a stop-loss order, you have limited your loss on the stock, in this case to about
7.5 per cent.
The loss is approximate because, when the order is triggered, it becomes a market order, which means that the sale will take place at the best possible price immediately available. Consequently, the stock could actually sell for more or less than $18.50. If the stock is trading in a fast market, the current price levels shown may not accurately reflect the most recent trades, so there is no price guarantee.
To avoid selling the stock at too low a price, you can put a "stop limit" in place as part of the stop-loss order. Let's say your stop limit is $16. If the stock falls to $18.50, triggering the
stop-loss order, but the next available price to sell is below $16, then the order will be halted and you will continue to own the stock until the price rises
above $16.
These orders usually stay active for one month, after which you should review, adjust and renew them.
Chasing the Gain
While these orders may protect your losses on a stock, how can you use this method to sell at a profit?
Consider what happens if the same $20 stock rises after your initial purchase and trades at $24. At that point, you can raise the
stop-loss order to, say, $22, essentially locking in approximately $2 in profits if the new stop is triggered. As the stock continues to rise, you can raise the
stop-loss order accordingly.
At some point — and with some stocks, this may be many months or even years — you will eventually get "stopped out," meaning that the
stop-loss order will be triggered and your holdings sold. The stock could continue to rise much higher, but more often than not, once a stop has been triggered, the stock will fall further.
Unfortunately, this tool is not perfect and in some cases you can get "whip sawed." A whip saw occurs when your stock trades low enough to trigger the
stop-loss order, causing you to sell out, but then recovers and continues to move higher. This can be very frustrating, but must be accepted as part of the strategy.
You can mitigate this risk by carefully selecting the
stop-loss price. For example, setting a
stop-loss price on a $20 stock at $19.50 will almost guarantee a sale due to normal daily fluctuations in the market. You want to capture a real change in the price trend resulting from a fundamental change in the company. So you need to set the stop-loss order a sufficient distance from the current trading price to prevent daily fluctuations from triggering it.
Determining the stop-loss price is more of an art form than a science and often involves a review of a stock's chart pattern. In fact, many technical analysts believe that, by reviewing chart patterns on the markets and individual stocks, they are able to glean information that fundamental analysts can't. However, fundamental analysts, with their use of more rigid and objective rules, are often the ones setting targets on individual stocks.
The assessments of technical analysts are more subjective in nature. They believe that patterns in human behaviour can leak information about a company into the market before it is reported on the company's financial statements. For example, if an automobile company dramatically ramps up production because of increased demand, its suppliers will be the first to know because they will receive orders for their parts before the cars can be manufactured. It is entirely possible that the suppliers' owners and employees will purchase stocks based on this observation. The reverse is also true; a decrease in orders to suppliers can indicate decreased demand, thus motivation to sell stock.
However, it can be up to three months after the cars are sold before the sales are actually reported on the quarterly financial statements. And it is these financial statements that fundamental analysts use to make their recommendations.
Balancing Mutual Funds
You can't place a stop-loss order on a mutual fund. In addition, the volatility on most (but not all) funds is lower than on an individual stock. While there is a
100 per cent risk on the capital invested in a stock, it is rare for a broad-based mutual fund to lose money over a
10-year period. However, there is an advantage to selling at least some of a fund that has risen in value.
Begin with an initial allocation based on your personal risk return profile and then rebalance to that allocation as needed. For example, if you and your adviser determine that
one-third of your money should be placed in growth funds and those funds grew to be
40 per cent of your account over time, then you should rebalance. To do this, you would switch
6.66 per cent over to an area that has fallen, such as bonds or other funds. If the proportion of growth funds fell to
20 per cent, you would have to switch money from another area to bring the proportional holdings back up to
33.33 per cent. This rebalancing is common with institutions like pension funds, but is not widely practised with individual accounts.
The second worst market fall in history took place from 2000 to 2003. To ensure that you don't lose any more, you must put strategies in place now to prepare for the next downturn.
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Larry Short, B.Comm., CIM, CFP, FCSI, CGA, is a Senior Investment Adviser with TD Waterhouse Investment Advice* in St. John's and is author of In Short: Secrets to Make Your Dollars Grow.