Stop-losses – reducing losses AND boosting growth
Posted by: Brian Dennehy
Warren Buffett’s first rule of investing is not to lose money. For private investors like you a stop-loss is key to your not losing money. Here I explore this very powerful tool, and how it can increase your growth.
In recent week’s we have referred to stop-losses on a number of occasions (in particular (When Should Investors Sell? Can we learn from Woodford troubles?) . A stop-loss means that you decide you will sell your fund if it falls by a certain amount – so you literally stop the loss from getting any bigger.
The valuation background – distraction?
Stock market valuations in the US are higher now than at any time in the last 300 years. History suggests the downside from here is 50%+. But valuations are far from fine-tuning tools, and can be a very costly distraction. The knowledge that you have stop-losses can give you the confidence to invest, and stay invested, despite apparent over-valuation – you don’t become obsessed with, and distracted by, valuations.
(I should add, if valuations are already keeping you up at night, and you aren’t convinced about wanting to grapple with the potential of losses of this size, there is no shame in sharply reducing your exposure to markets now – your peace of mind is a very important but often overlooked driver of how you should be invested at any time).
There are two issues for you to decide in respect of your stop-loss:
At what level should you sell: e.g. when it drops 5% or 10%?
And when should you buy back in?*
We have researched this in great detail, and crunched these numbers over four decades, testing a number of permutations. There is no perfect answer, but, in a nutshell, the most effective stop-loss method was selling on a 10% fall.
Selling with a 5% fall continually whip-saws you in an out of markets – this is costly and not recommended.
Stop-losses INCREASE your profits
If you applied the above stop-loss idea to the UK index (the FTSE 100 index) it hurt performance, which is what we would expect. Typically there is a price for a stop-loss – you achieve less volatility, but at the price of less growth.
But when you apply the same stop-loss to our Dynamic UK Growth Portfolio the results improve! (This is the portfolio linked to the UK All Companies sector, where performance numbers were recently updated in Extraordinary Profits. Ordinary Funds.)
I know there have been a large number of new readers in recent weeks, so here is a bit more background than normal. For long term readers, skip to the heading below But "stuff" goes wrong.
If you would like to explore the story behind this do take a look back at The Mystery of the Missing £941,710. In a nutshell, the process is:
Buy the best UK growth funds of the last 6 months.
Sell this 6 months later...
...and then buy the top performing funds of the then most recent 6 months.
Repeat this process every 6 months.
So simple it is insulting.
From 1st July 1994 until now, the FTSE 100 index is up 463%. Doesn’t sound terrible…
…until you realise how you could have applied a straightforward process to generate 3x more growth.
You didn’t do this by taking daft risks, but by simply having a clear process to identify funds with greater potential, and applying it with some discipline – albeit only about 30 minutes work twice a year, which is hardly burdensome.
To put this in context, supposing you woke up tomorrow and you were given not a 10% pay rise, or even a 50% pay rise. But a 300% pay rise! You would be ecstatic. This is your potential. You just need to pay attention for 30 minutes twice a year.
But “stuff” goes wrong
Applying that stop-loss strategy set out above to the Dynamic UK Growth Portfolio not only did the performance go up (to 1746%) but hugely less volatility** – in fact about 50% less compared to the portfolio without the stop-loss and the stock market index.
Watch this space
There will be a series of exciting innovations for you in coming months. For example, we will talk about the stop-losses in more detail in upcoming live teleconferences – which will be a regular feature, where you can ask your most pressing questions. And you will love our latest portfolio ideas – thoroughly back-tested, very profitable.
Watch this space.
In the meantime, we’ve had some more fun with these numbers over in Beauty and the beast
ACTION FOR INVESTORS
Stop losses can boost growth...
...as part of a comprehensive plan
* When you back buy is very straightforward – it doesn’t involve guesswork or crystal balls, and will be covered in the upcoming teleconferences and further blogs in the next couple of months.
** This is based on the “monthly maximum drawdown” from 1/7/94 to 7/9/17 calculated from data provided by FE Analytics