Everyone loves to talk about their stock market winners.
Yet when it come to their losers, all you generally hear is silence. Of course, this doesn’t mean the loss makers aren’t on investors’ minds.
In fact, the decision of what to do with your worst performing stocks can create a fair bit of anxiety.
With the recent stock market drop, many of you may find yourself in that position now — thinking, ‘what should I do with my losers?’
Should you sell, accept the loss and move on? Or hold on in hope the price rebounds?
It can be a tough decision to make.
All investing involves a level of risk. It’s how you manage this risk that can make the difference between reaching your financial goals or falling short. It’s not always easy, but you have to accept that some investments just won’t pan out. Then you can get back to talking about your winners.
Turning a blind eye to your worst performers could see them drag down your whole portfolio. Picking a single stock that jumped 400% doesn’t sound so impressive if your total portfolio is in the red.
There’s often an obvious, or fundamental, reason for a share price to fall — lower revenues or a cut to earnings guidance, for example. It should go without saying, but you should sell a stock if it no longer looks attractive – according to whatever metrics you use.
If the company’s future looks doubtful, for whatever reason, sell. Replace it with something better. It’s that simple.
On the other hand, good companies’ share prices can drop for no clear reason. This is where the decision is not so straightforward, and why you need an exit strategy in place to protect your portfolio.
What should you do with stocks that have fallen but still seem to be quality investments?
You can hold on to them, confident that, at some point, they will bounce back. Yet this isn’t always the best strategy. A paper loss — rather than an actual realised loss — doesn’t mean you haven’t lost.
Let’s say you hold on to a stock and it loses half of its value. The share price then has to double, just to get back to where it was when you bought it.
If it falls 70% from your purchase price, you’ll need a 300% gain to get back to where you started. A 90% loss? Then you’ll need a 900% turnaround!
And don’t forget the opportunity cost of not being in something else that’s rising. While you’re following a stock to the bottom, you’re missing out on gains from winning stocks.
A better idea than holding them to the bottom is to have a clear-cut exit strategy. You should put as much thought into planning your exit strategy as you put into the research to buy the investment in the first place. And, just as importantly, have the discipline to follow it.
Know when to cut your losses
Using stop losses is a way to add discipline to your decision to sell. They are a commitment to exit a position once a stock falls to a certain price. They are designed to limit an investor’s loss.
Here’s how they work…
When you buy a stock, decide on a lower price that you will sell at if the share price falls. There are many ways to decide at what that level should be. It can be a certain percentage below the entry price. It can be set at a level that has previously acted as support or resistance. Or you may choose some other level. The level you choose doesn’t matter nearly so much as having the discipline to stick to it.
Trailing stop losses go a step further — protecting against losses AND locking in gains.
Trailing stops are just one of the tools we employ with the Guild’s portfolios to minimise risk and maximise returns for our members.
The trailing stop level isn’t set at a fixed price. Instead, it is set at X% below the share price. As the share price rises, the stop will rise with it. The stop will never be lowered, so that it remains X% below the stock’s highest price since you’ve owned it.
As the stop loss level trails the share price higher, it acts to lock in gains and limits losses.
A simple form of the trailing stop strategy is a 25% rule. Once a stock falls 25% from its highest price — since you’ve owned it — you should exit the position. Say you buy a stock at $50, and it rises to a high of $100. You should sell it if it closes below $75 – no matter what.
Applied across each stock in your portfolio, you can be confident that you don’t face massive losses.
Let’s say you have a $100,000 portfolio. You invest this equally across your investments. And you don’t invest more than 5% of the total, or $5,000, in any one position.
If you apply a 25% trailing stop loss, the maximum amount you can lose on any one stock is limited to $1,250 (25% of $5000).
This loss is just 1.25% of your entire portfolio. So no single failed investment will seriously dent your portfolio. In fact, to lose half the value of your portfolio you would need to see more than 60 straight losses of 25% each. While that is possible, it’s extremely unlikely.
For longer term investors, 25% is about right. For short term traders, or for less volatile stocks, 15% may be better. Place the trailing stop as close to the share price as you can allowing for a stock’s day-to-day, or week-to-week volatility.
For extremely volatile stocks, you may want to widen your stops even further so that you’re not stopped out on a particularly volatile day of trading. As mentioned above, the exact number is not what’s most important. What really matters is the discipline to stick to it.
Applying the stop
You can place stop loss orders with your broker so that the stock is automatically sold when the price falls to that level. But there are some risks involved with automatic stops.
If the stock falls rapidly and gaps down — during a flash crash or on breaking news — your stock will be sold at the next available market price. This price could be much lower than the stop level.
Another issue with automatic stops set with your broker is that the order is transparent. This leaves your position open to manipulation by large institutions. In what’s known as ‘running the stops’, a stock is sold down triggering a large number of stop loss orders — which are usually found at significant support or resistance levels. Once the stop losses are triggered the stock then reverses direction and rallies. This is more common in low liquidity stocks, but a risk nonetheless.
A better option is to keep track of the stop levels yourself and sell at market once it has fallen to its stop level.
If you’re worried that you won’t notice when the stock falls, you can set up price alerts through your brokerage platform. The alert will be sent once the share price falls to a certain level. This could be at the stop level, or just above. There may be a (minimal) fee for this service, but it could save you from unnecessary losses.
The important thing is to exercise discipline — especially in a falling market. Keep note of where your stop losses are, have a clear idea of what losses are acceptable to you, and then stick to that limit.
Appropriate stop loss levels and the discipline to stick to them are critical to protecting your investments. Think of them as a safety net. You can always buy back in at a later date. But there’s no need to hold a falling stock all the way to the bottom.
Investment Director, Albert Park Investors Guild