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Stop-losses. A key part of your plan

Posted by: Brian Dennehy
Membership level: Free

 

 
We’ve had a lot of questions on stop-losses since we started sending alerts for Gold Members.  It’s been great getting comments on how you actually use the tools, keep that feedback coming.  Here, after a recap, we highlight how different investor types might apply a stop-loss. 

If you haven’t listened to the teleconference from May 2018 then the recording is available here.  Do have a listen.  Also take a look at the stop-loss page.  If you haven’t looked at it before some of the references below may not make complete sense.

Now, let’s have a quick recap on why we recommend a stop-loss in the first place.

Taking a step back, think about why you have a stop-loss.  At its most basic, the primary purpose of a stop-loss is to protect your capital, not to second guess the market – it is not a prediction tool.

It protects your capital value from the possibility of extreme and prolonged falls.  You do not have a stop loss because you know that such falls will ensue but because of the possibility of such extremes.

The best example is still Japan – which peaked in December 1989 and is still down about 40%.  This is why we say you are protecting yourself from “The Japan Problem

If you are investing a significant chunk of your life savings this is a very serious point.  Prolonged falls of 50%+ over an extended number of years can destroy not just a significant part of your capital, but your life plans.

Even if you have a small proportion invested or are relatively young, take the chance to get into good habits – it will pay off handsomely in the long run.

History is littered with people whose excuse for not preparing for extreme events is “It never happened before”.  You mustn’t try and predict the precise nature or timing of an extreme event – you must simply take on board that extreme events do happen.

Nor should you kid yourself that you (or I) have some special insight as to the fate of your individual stocks or markets generally – you don’t, I don’t, no one does.

Control what you can control.

We send alerts to you when indices that we track hit certain levels (8% or 10% down).  These are designed to prod you, not panic you.  The purpose is to prompt you to look at your current fund values in the context of the stop-loss that you have previously built into your investment plan.

With this in mind, your precise strategy for stop-losses and cash levels is a very personal matter.

For example, while we might agree that a stop-loss trigger at 10% is fair in many instances, the action you take will vary depending on your personal circumstances plus your approach to investing, and how you tend to react when uncertainty increases.

One investor might have the following characteristics:

  • Age 50, a confident investor, managing all of his own investments including his SIPP
  • He has 50% UK stock market, 50% global stock markets (of portfolio value which is invested)
  • He has substantial profits across all holdings, particularly since 2009
  • Currently he has 20% of his portfolio in cash, where normally it might be under 5%
  • If stop-losses are triggered the plan is to have no greater than 50% in cash
  • This investor is comfortable with the idea of re-investing the 50% cash at much lower levels, and thereby averaging his overall purchase prices
  • He monitors his fund prices regularly, and will sell when the price on a fund is 10% lower than the recent high
  • As a backup, from day to day he monitors key indices (e.g. FTSE 100 and Nikkei 225) to prompt him to check fund prices

There are many possible variations, for example, a second investor also has a similar profile, with substantial profits since 2009 but she can’t see the point in leaving 50% invested with her gains being eroded with risk so elevated – she will be content to retain most of her post-2009 gains by going to 100% cash on the stop-loss being triggered, and patiently waiting for another great buying opportunity.

A third investor is age 60, and less relaxed.  Partly because he will be relying on this capital for retirement income in about 5 years, and cannot afford a Japan-style hit, partly because he is very busy, and partly because, though ordinarily calm and thoughtful, he knows that when markets get shaky, he tends to make bad and impulsive decisions. He also prefers the move to 100% cash when stop-losses are triggered fund by fund.

The fourth investor is age 45.  His portfolio is more aggressive (biased to Asian fund sectors plus the Bonkers Portfolio).  He has substantial profits in place over the last 10 years.  He used to have a stop-loss at 12% to give a bit more flexibility as his funds tended to be more volatile, and he is now very practiced and comfortable applying a stop-loss.  Recently he has moved this to 15%, which takes into account both the expectation of greater volatility short of catastrophic falls, and the size of his profits – if he took a 15% hit he still has all his original capital and substantial profits intact.  He is also not worried about being 100% in cash on sharper falls, as he has seen and exploited many opportunities and knows he just needs to be patient.

Our last investor is age 35.  She started small, investing monthly from 10 years ago, and has enjoyed taking more risks (she’s younger and investing monthly) and has largely employed the Bonkers Portfolio approach – her view was, with the performance numbers, why would a young person do anything else?  She has a 15% stop-loss, and will be content to go to 100% cash, and then use this cash to bolster her continuing monthly investing from surplus income.

In each case, as well as rules on the application of the stop-loss, each of the above also has rules on the timing of re-purchases, to make sure you systematically get back into the market, even in the face of on-going volatility.  More on that in the next stop-loss blog.

ACTION FOR INVESTORS

  • Do think about your stop-loss strategy.  It will be personal to you, so don’t just follow the crowd.
  • Do have a plan for re-purchasing.  This can be harder than the decision to sell.  Make sure it’s clear.
  • Don’t panic.  Once these two are in place you should be in a much better position to weather market storms.

FURTHER READING

Topic: Portfolio building


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