If you spend even a bit of time reading financial literature, you’re bound to come across the phrase, ‘cut your losses and let your profits run’. In the investment world it’s an overused cliché. But like many clichés, there is more than a little truth behind it.
This truth is that to be a successful long term investor, knowing when to sell is as crucial as knowing when — and what — to buy.
When it comes to the buying side, the Guild’s Investment Director, Meagan Evans, spends a lot of time — trust me, a lot — researching the ins and outs of every company before recommending it to our members. Each stock must meet a strict list of critical criteria before it’s even considered for the Guild’s portfolios. Sticking to this philosophy is one very important way to reduce your investment risks.
But there are certain events that no amount of research or insight will allow you to predict. War, natural disasters, and major economic shocks — positive or negative — are a few examples.
Sure you’ll find some analysts who can hold up their hand and say they predicted the impending GFC back in early 2007. But almost certainly these same people were predicting an imminent financial meltdown in 2004, 2005, and 2006 as well. That’s like putting your chips on number 21 in roulette over and over again. Eventually you’ll guess right. But anyone who’s been watching you will know it was just that…a guess.
At the Guild we don’t like to guess. And we know that every now and again an unforseen event will impact one of our stocks. When that impact is positive…hurrah! When that impact is negative, there’s not much you can do…except stick to your exit strategy.
The Guild recommends a 25% trailing stop on every investment. If the stock is performing well, you hold onto it. If it ever drops 25% below the peak price it reached since you bought it, you sell. This strategy takes emotion out of the picture. It allows you to lock in your gains and keeps you from chasing a falling stock lower.
Yes, there’s always an off-chance that the day after you sell the stock, it rebounds. But — maddening as those cases will be — you’ll find that’s the exception, not the rule. If you ignore your stop loss you’re only guessing that your investment has hit bottom and will turn around. That decision, of course, is yours to make. But as I said, we don’t like to guess.
To give you an example, two of the Guild’s stocks triggered their trailing stop losses in the last five weeks. RCR Tomlinson [ASX:RCR] hit its trailing stop on November 7. It hit its stop loss of $2.54 and we recorded a sold position at $2.38. Just over three weeks later, Halliburton [NYSE:HAL] triggered its stop loss of $41.89, and we sold at its opening price that night at $41.29.
Now these are both quality companies. Otherwise Meagan never would have recommended them in the first place. But they were victim to one of those pesky unforseen events. In this case, that event was plummeting resources and oil prices. RCR and HAL are heavily involved in the mining and energy sectors. And since early October oil has fallen off a cliff, dropping around US$30 per barrel.
Both stocks recorded initial gains following the recommended buy date. If you’d bought and sold them both on the recommended dates, you would have recorded an average loss of 16.9% (taking international exchange rates into account).
That’s not great…to say the least. That’s why you follow the Golden Rule and diversify appropriately into a broad range of non-correlated companies. Three of the companies Meagan has tipped since August are up 45.73%, 16.21%, and 19.49% respectively.
But I won’t prattle on about the Golden Rule today. Today is all about adhering to your stop loss.
What if you’d grown attached to HAL and RCR and held on to them, guessing that they were set to turn around? Today HAL is trading for US$39.23…that’s down almost 7% since hitting its trailing stop. RCR has faired even worse. Its currently trading at AU$1.99, down around 22% since hitting its trailing stop.
You may wonder why we recommend setting your trailing stop at 25%? Why not 10%…or 60%?
The graph below goes a long way towards answering that question.
This graph demonstrates the gains you need to make to offset any losses on an investment.
Let’s say one of your investments falls 10%. Obviously that’s not what you want to see. But so long as nothing has fundamentally changed with the company, I wouldn’t recommend exiting your position at this level.
Stock markets are fickle beasts. Even reliable blue chip businesses can lose 10% on the release of poor economic or industry news. If you set your stop level too low, you’ll be selling quality companies that will most likely bounce back and offer good returns in the longer term.
Importantly, you can see that if a stock drops 10% it only needs to rebound 11% to recoup your losses. With the kind of quality stocks in the Guild’s portfolios, that type of rebound is well within expectations.
What if you go to the other extreme and choose a 60% trailing stop? Well, as you can see from the graph, if your investment nosedives, you’ll need to make a 150% gain elsewhere just to break even. Now I don’t know about you, but I don’t see 150% gains coming across my desk on a regular basis.
The 25% stop loss level is not an arbitrary figure. This level is high enough to ensure you don’t get stopped out with modest price fluctuations. And yet low enough that you can recoup any losses by making a 35% gain on another investment.
And, of course, the trailing stop is set from the highest price your investment has reached. Ideally, it’s made good gains before running into any trouble. You may even still turn a profit, or in either case limit your loss to less than 25%.
At the end of the day, no one likes to sell a promising investment. And when a good company has already fallen 25% or more, it’s nice to think that it’s set to bounce back. But the facts tend to show otherwise. In fact, RCR and HAL have both fallen around 45% since their peaks earlier this year.
With all that said, RCR and HAL remain excellent companies. And when the massive shakeup in the resources markets finally calms down they could very well outperform their competitors. If you want to hear from us to find out when they may be good buys in the future, click here.
But until then, there are better opportunities out there preserve and grow your wealth.
For The Daily Reckoning Australia