The Most Important Phenomenon in Investing

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Investors returned from a three-day holiday and found stocks and gold right where they wanted them. Neither registered any change yesterday.

So let’s return to the nuts and bolts of investing

Take a look at your portfolio. Imagine how much better off you’d be if all those 50%…60%…80% losses were removed.

Unless you’re a true ‘deep value’ investor, and happy to ride out these drawdowns, you could do that by using a trailing stop.

That’s the easy part.

More important’, says TradeStops.com’s Dr Richard Smith, ‘is that trailing stops allow you to take full advantage of your winners.’

You buy a stock. It doubles. What do you do?

Many investors would sell, feeling that they had made a good profit. Why be greedy?

Often, they then watch as the stock goes higher and higher, as they sit on the sidelines grousing about having gotten out too soon.

Old-timer Richard Russell, of Dow Theory Letters fame, tells the story of how he invested in Buffett’s Berkshire Hathaway in the early 1970s.

The stock doubled and he sold. He has been kicking himself ever since. Class A Berkshire Hathaway shares, which Buffett bought for $11 in 1962, are now worth $222,636.

Cut your losers… Let your winners run

The most important phenomenon in investing is one most investors aren’t even aware of,’ says Smith.

When a stock goes up you are pleased…but the effect grows weaker over time. Emotionally, investors become blasé about it. But when a stock goes down, their pain increases the further it falls. Investors become more concerned, as their losses increase.

So they tend to sell their winning positions. As for their losses, they stick with them hoping to get back to breakeven. In other words, they do the opposite of what they should. They cut their winners and let their losses run.’

Stop losses are a tool you can use to help fix this problem. You set a stop loss at a level that leaves you with a risk you can tolerate. That will keep you from taking a big loss.

And when you get a stock that is a winner, rather than sell it out, just put on a trailing stop and let it run.

Winners are winners for a reason. Often, they will be far bigger winners if you stick with them.

This strategy forces you to cut your losses. And it permits you to hold on to your winning positions without the risk of giving up your gains.

The perfect stop

Smith figured this out by analysing the portfolios of newsletter editors, George Soros, Jim Cramer and others. In almost every case — a notable exception was value investor Warren Buffett — stop losses created a substantial improvement in performance.

Then he turned his attention to improving the standard stop loss. What he came up with was a ‘smart stop’ — one that was tailored to the individual investment.

Not all stocks are created equal,’ he explains. ‘Some are volatile. And some are not. You don’t want to get stopped out of a volatile stock because you set your stop too tight. And if you put your stop too loose on a stock without much volatility, it won’t serve its purpose.’

Smith came up with a formula for the perfect stops. They vary from as little as 10% to as much as 80%. Using these ‘smart stops’ improves your returns.

For example, a study of Steve Sjuggerud’s True Wealth portfolio, since 2000, showed the following results:

Putting $1,000 into each of Steve’s recommendations since 2000 produced about $30,000 in profit by 2014. Adding a simple 25% trailing stop turned the $30,000 into about $50,000. Using ‘smart stops’ raised it to $55,000.

Then Smith went one step further. He developed a formula to tell you when you should get back into a stock after getting stopped out.

He calls it his ‘re-entry rule’. Adding his re-entry rule to the formula adds another $15,000 to your returns. All together, his tools turned a $30,000 profit into a $70,000 profit — on the same basic trade.

For us, the conclusion is simple. Stop losses work — for most people, most of the time.

Regards,

Bill Bonner,
for The Daily Reckoning Australia

Editor’s Note: Meagan uses trailing stops in each of the Albert Park Investors Guild portfolios. To learn more about the Guild and its three distinct portfolios, click here.

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Bill Bonner

Bill Bonner

Best-selling investment author Bill Bonner is the founder and president of Agora Publishing, one of the world's most successful consumer newsletter companies. Owner of both Fleet Street Publications and MoneyWeek magazine in the UK, he is also author of the free daily e-mail The Daily Reckoning.
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