Managing the downside - basic risk management for tough markets
I genuinely do sympathise with anyone who started investing in stock markets for the first time in January 2016. It's not been an easy environment - but let’s get one thing straight it’s not exactly been bad. If you've invested through 2000 and/or 2008 you'll know what bad really is and it’s much, much worse than it is now. The year to date return for the FTSE 100 is a 4.4% fall, which is pretty much on par with last year’s lame showing and perfectly in the range of normal for stock markets. From comments on the Stockopedia.com website it’s been clear that many investors are nursing losses worse than this and with all the recent uncertainty over Brexit they are wondering what to do. What’s going to happen next? Well I’ve learnt the futility of forecasting so can proudly say I have absolutely no idea, but I do know what’s happened in the past and while history never repeats, it often rhymes. So let’s read the rhyme.
FTSE 100 return history
In my database I’ve got FTSE 100 price histories back to 1984. That’s a period that covers 2 massive bear markets and one of the longest bull markets in history. It’s not long enough for a complete analysis, but it’s probably a pretty good proxy for what happens in the stock market in general. I don’t like the FTSE 100 as an index at all, but it’s the UK bellwether and widely followed so it’s a good enough place to start.
The image below shows the annual percentage return each calendar year since the end of 1984. As you can see it’s a picture that shows lots of positive years interspersed with some vicious setbacks.
The FTSE has returned an average annual return (excluding dividends) of 6.7% per year in this period and the standard deviation from the average is 15% annually. So in a typical year the FTSE has returned anything between a loss of 8% and a gain of 22%.
In this 33 year period there have been 23 up years and 10 down years. The average investor in FTSE stocks will have seen a gain year on year around two thirds of the time. Below is a histogram of the returns which helps us visualise the distribution. The height of each column in the histogram is the number of years that have shown returns in each range. e.g. there have been 11 years that returned between 10 and 20% in a single year.
But it’s the downside we’re all worried about. Once in every three years there’s been a loss. Once in every five years there’s been a ‘really bad loss’ (greater than 8%). The worst single year loss was 2008 which saw a 31.3% fall, and the worst peak to trough drawdown over this time was around 50%.
Base Rate Expectations and handling losses
So that’s the past, that’s the reality and that’s the range of results we can likely expect from stock markets in the future. The above statistics set a base rate for future expectations - we should expect to see stock market losses year-on-year a third of the time and bad losses once every five years. If you can’t handle this idea you shouldn’t even think of investing in stock markets - it’s par for the course.
Warren Buffett once said that rule #1 is to never lose money, while rule #2 is never forget rule #1. Now we might be able to improve on the FTSE 100 returns by investing intelligently, but even if we have the best system in the world we should realise it’s impossible to avoid these regular rhythmical equity market losses. Rather than avoiding losses, or denying them, the best mental approach is to accept them and put in place a strategy to minimise them.
The old maxim for stock market success is that we should ‘run winners and cut losers’ which everyone knows but almost everyone disobeys. What most investors do is hold onto their losers and sell their winners due to a cruel twist of evolutionary fate that has made our brains poorly wired for investing.
I love this story by Fred Kelly author of Why you Win or Lose that was recounted in Bill O’ Neil’s “How to Make Money in Stocks” that sums it up:
A little boy was walking down the road, when he came upon an old man trying to catch wild turkeys. The man had a turkey trap, a crude device consisting of a big box, with the door hinged at the top.
This door was kept open by a prop, to which was tied a piece of twine, leading back a hundred feet or more to the operator. A thin trail of corn scattered along a path lured turkeys to the box. Once inside, the turkeys found an even more plentiful supply of corn. When enough turkeys had wandered inside the box, the old man would jerk away the prop and let the door fall shut. Having once shut the door, he couldn’t open it again without going up to the box, and this would scare away any turkeys lurking outside. The time to pull away the prop was when as many turkeys were inside as one could reasonably expect.
One day, he had a dozen turkeys in his box. Then one sauntered out, leaving 11. “Gosh, I wish I had pulled the string when all 12 were there,” said the old man. “I’ll wait a minute and maybe the other one will go back.”
But while he waited for the 12th turkey to return, two more walked out on him. “I should have been satisfied with 11,” the trapper said. “Just as soon as I get one more back, I’ll pull the string.”
But three more walked out. Still, the man waited. Having once had 12 turkeys, he disliked going home with less than eight. He couldn’t give up the idea that some of the original number would return. When finally only one turkey was left in the trap, he said, “I’ll wait until he walks out, or another goes in, and then I’ll quit.” The solitary turkey went to join the others, and the man returned, empty handed.
I’m sure I’m not the only one who has seen a few turkeys leave the trap in recent months… what we’ve got to do is learn to shut the door.
Shutting the turkey trap
Most great traders keep their losses a small as possible by using stop losses. It’s hard to admit we’re wrong, but great traders are humble and don’t feel the need to be right. Steve Cohen, the controversial hedge fund manager, once said “my best trader makes money 63% of the time. Most traders make money only in the 50 to 55% range. That means you are going to be wrong a lot. If that’s the case you better make sure your losses are as small as they can be and that your winners are bigger.”
The research on using stop losses is clear. While they don’t necessarily improve returns, they do reduce risk. More than this the use of stop losses effectively inoculates us from our evolutionary bias to hang onto losers and sell winners - known as the ‘disposition effect’ by behavioural scientists.
Every investor should ask themselves - "How will I feel if I find my portfolio 30% or 50% down?" I don't know of many people who have limited capital who can cope with that - I didn't cope well with it in 2008. But it’s statistically likely and will happen again and again. If we can’t tolerate falls of this size we either we put a risk management strategy in place to avoid it or we get the hell out of the stock market. 30%+ equity falls are perfectly normal... and no system used - whether the StockRanks or investing in a fund manager such as Neil Woodford is going to save us from it. Here's Neil Woodford's 32% fund fall in 2008 in a conservative dividend/value strategy.
Where to set stops
There’s no consensus on where to set stop losses but many professional traders use a rule of thumb where they risk no more than 1% of their capital on any single trade. We can translate this 1% risk rule into a rule of thumb for fully invested long-only portfolios with some simple maths.
If an investor owns 20 stocks in a portfolio, then they’d have an average 5% in each position. A 20% fall in any one equates to a 1% portfolio loss. So 1% risk management means cutting losses at 20% on each position. In a very worst case scenario where all our stocks fall by more than 20% our total capital risk is 20% of our portfolio. There are plenty of advocates of tighter stops (in the 8% to 10% range), but tighter stops require a lot more day to day management and market timing, something that most DIY investors don’t have time for.
It can of course be galling getting ‘stopped out’ of a position only to see the stocks we previously owned bounce right back. But there’s nothing stopping us getting back in to the same position when waters are less full of sharks. I’ve no crystal ball, but with global market momentum so poor risks appear to be more skewed to the downside than the upside so prudent risk management makes sense.
We all have to take responsibility for our own results in the stock market. We act even when we don’t act. It can make a lot of sense to review our portfolios and ask ourselves "Have I shut the door or am I waiting for my turkeys to return ?"
About Edward Croft
Co-founder and CEO here at Stockopedia.com. I was a wealth manager, then full-time private investor before setting up Stockopedia. I believe passionately in the power of data-driven investing to improve investment results. Oddly obsessed with the StockRanks.
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I am sure you are right about the stops Ed, I use technical analysis alongside the fundamentals, as well as having a rule that I never take a stop of >10% which sometimes gets breached, but not often. And I use other indicators to decide how much I am in the market and how much in cash. Survived 07-09 very well, and sleep better. After several decades of investing,if there is a holy grail, it has to be about managing risk well. thanks for the site, and the analysis, and the thought provoking articles
Hello Ed,
"We should ‘run winners and cut losers’ which everyone knows but almost everyone disobeys. What most investors do is hold onto their losers and sell their winners due to a cruel twist of evolutionary fate that has made our brains poorly wired for investing."
There is a natural mechanism in the British tax system that encourages paying attention to this maxim.
It's called Capital Gains Tax.
Suppose you want to run a balanced portfolio, outside an ISA or other tax shelter. At the end of the year you sell your losers, add in the CGT allowance to arrive at a total sum. Then cash in some part of the winners in the portfolio to set against the total sum of losers plus CGT allowance.
You thus end up, at the beginning of the next tax year, with all winners and no losers.
The objective is to always use your CGT allowance.
After the exercise you have some new money to invest and balance the portfolio,or hold in cash over the summer months.
Of course you have to a few good winners to get the process started but after a while it becomes a virtuous circle.
I use this system myself and the percentage gains, in my portfolio outside of my ISA investments, far exceed the gains inside my ISAs.
Regards,
Randval.
Actually running winners is harder than it sounds, what if the share falls 10%, do you sell, what about 15% or 20%? Its happened to me, I had a winner up over 80% in a year, Ab Dynamics (LON:ABDP) went up to 350p then it started to fall, so i sold out when it fell 10%, 315p, it then fell to 280p now down 20%. Director bought 3,400 shares no big deal. But then slowly went up, then quickly up to 502p, before falling back to 400p in the last week. So how do you judge when to sell winners?
10% stops I found I was getting stopped out all the time. 20% I found thats where many bottomed out and then bounced back. Stops don't work if there is bad news when market is closed, the market makers have already marked the price down before the market opens as I found out on some such as Lakehouse (LON:LAKE) and Sepura (LON:SEPU). Others such as Entu (UK) (LON:ENTU), Dialight (LON:DIA) and Solid State (LON:SOLI) I got out before the big fall.
Herbie
I think it's almost impossible to run winners with stop losses in place. I think stop losses are a trader's tool but not for investors.
I suspect too that AB Dynamics will play out as a good long term investment.
Hi Ed.
Good article - thank you for that.
On the subject of using stop losses, my "monkey brain" has evolved a slightly different approach, in that I tend to use different types of stocks to achieve different things. In this respect, I am a bit of a "farmer" with occasional "hunter tendencies". In simple terms, I categorise my shares into three types: staple crops; new varieties and free range.
The staple crops are core holdings in larger cap, high dividend payers such as British American Tobacco (LON:BATS) . I buy these and reinvest the dividends via scrip issues and basically forget about them. I occasionally take a harvest of a small part of the holding if I need the cash but ignore market falls on the basis that over time this simply makes the purchases through future dividends cheaper.
The new varieties are typically found in the mid cap/smaller cap sector or by using new investment metrics such as following a Naps type approach. These tend to require a closer scrutiny and I am more rigorous in applying a 20% stop loss system. Over time I tend to plant more of the successful NVs and cut out the losers.
The free range tend to be found among small caps or AIM and are often sourced by following up on certain share blogs (e.g. Paul's SCVR) or delving into some of the Guru screens for ideas and then following up with my own research. These tend, initially at least, to be "punts" with small amounts of capital that I am prepared to accept much greater volatility with. I generally don't apply stop losses here, other than accepting that the ante stake might be completely lost (I don't use leverage). Some will be multi baggers and some will run down to nothing. Depending on my market view from time to time, I will try and take out my initial investment capital from the multi baggers and then have a "cost less" free run from any further upside.
Over time certain stocks migrate between the classes and there are numerous hybrids which might fall between two stools e.g. NVs vs. Free Range and get treated accordingly. Likewise, my view might change on the role that I expect any given share to play in the overall portfolio.
Gus.
Thanks for the reply Ed. Along, I'm sure, with plenty of others here, I have several "turkey droppings" that have hardly been worth selling over the years - your turkey story is an excellent analogy for the process of neglect that leaves us with a couple of shares hardly worth selling and with minimal hope of recovery.
Regards.
PS. Aminex anybody?
Hello Muckshifter,
First of all thank you for some profitable insights you have given me over the years.
Domino Printing Sciences was taken over in tax year 2015/2016 this T/O generated profits outside my ISAs The profits were liable for CGT..
Fairly soon afterwards I sold Aminex at a small loss, Stanley Gibbons at a much larger loss and Indigo Vision at a loss.All to set against my potential CGT liability.
Since then AEX has fallen by 10% approx
SGI by more than 90%
IND by more than 40%
In addition I limited my liability for CGT..
Of course I was lucky that things worked out well, but I believe this is an illustration of an effect that I never seen commented on before. The effect acts to counter our perverse tendency to run losers and sell winners.
Regards,
Randval
You may be right and yes I'm looking to buy back in to Ab Dynamics (LON:ABDP). My stop loss was not an auto one. If I had a larger holding I would not have sold all, really I should have larger holdings on my winners, haha. Its difficult to judge smaller companies, look at Fevertree Drinks (LON:FEVR) and Trakm8 Holdings (LON:TRAK). Some investors set targets and then sell but I feel they lose out on the big winners that 10 bag and more.
I agree capital gains tax is a real pain but now with the change in dividend tax things are more complex, I will have to sell some to avoid tax then capital gains comes into play, thanks George, real pain and no gain for the tax man. Now I'm looking to transfer some of the high dividend ones in my ISA but there is only £15,000 available this year.
Actually running winners is harder than it sounds, what if the share falls 10%, do you sell, what about 15% or 20%?
You might want to consider using Ichimoku Charts as these will help you to visualise:
- the overall trend (or no trend)
- key support and resistance points
The 'clouds' in Ichimoku charts represent key areas of consolidation. The thicker the cloud the harder it is for the current price action to penetrate the cloud. Often the price action rebounds of the top or the bottom of the cloud providing support.
If I'm happy with the quality of a share I tend to sell when the price breaks below the cloud either in a strong way or if it stays below the cloud for a few days.
If I'm less happy with the quality of a share, e.g. the quality rank has deteriorated but I'm still riding price momentum I will shift my notional stop loss to a tighter support position. For example where the fast and slow moving averages cross (Kijun Sen and Tenkan Sen).
With respect to Ab Dynamics (LON:ABDP) if you load the chart you can see ...
- The rightmost cloud is Red instantly telling us that this stock is in a Bearish state.
- The price has just dropped below the cloud, another bearish indicator. Will it hang on and recover like it did back it February?
If I was happy with the quality of this company I'd be watching it closely over the next few days. If it broke lower I'd sell.
You could have also used the moving average cross (Tenkan Sen/Kijjun Sen Cross) in early June to exit quite close to recent highs. Those moving averages haven't crossed since early March but in some stocks this doesn't allow a stock to breathe as it pauses for a rest after strong gains.
Another option to exit is price crossing the slow moving average (Kijun Sen Cross) but again this can generate a lot of signals and doesn't allow a selection to breathe.
I just find using Ichimoku charts helps me to somewhat more objective.
Not sure if that helps
Phil
Thanks Phil, I did have a look at those charts when you mentioned them last year but I did not really understand them but seems to have worked with Ab Dynamics (LON:ABDP). I looked at Trakm8 Holdings (LON:TRAK) and they seem to be bear all the time even though the share price is going up and down between 200p and 280p. Its something I will try and study more then, not sure if they will work next week which is an unusual event for the UK markets.
The Ichimoku charts give 5 signals. When a stock is strongly trending upwards then they will all align Bullish and when the stock is strongly trending downwards they will all align Bearishly.
So for Trakm8 Holdings (LON:TRAK) there would have been strong Bullish alignment from August last year to mid Jan 2016. Then one by one the signals would have started to turn bearish, first price crosses slow moving average, then slow and fast moving averages cross, then price cuts through the cloud, then cloud turns bearish and finally the lagging price line cuts below the historical price. Hey presto the stock is fully bearish. That occurred in early February (bearing in mind that the clouds are projected forward 28 days. You'll see that the tip of the cloud on the right hand extends beyond the current price)
Then Trakm8 Holdings (LON:TRAK) entered a period of consolidation signified by horizontal clouds changing from bullish to bearish and back again.
That's why I'm always looking for a stock breaking out. I don't want to buy into consolidating stocks I want them on the move. I also want all five signals indicating Bull run.
The only time I ignore the charts is when there is a market wide event occurring such as Brexit.
I could talk more about the fact that 4 of the signals generated have strength indicators, as in Weak, Neutral and Strong. It you're interested there is more detail on the site which explains a little about them.
Hi Phil,
These are absolutely fascinating! I've just run my entire portfolio through the checker and all but 2 came up bearish! Lots of Brexit in that, I guess, but still slightly disconcerting. But great to have a useful tool for future share assessment. Thank you!
Paul
Yes just doing that I have a few more Boohoo.Com (LON:BOO), Bovis Homes (LON:BVS), Burford Capital (LON:BUR), Debenhams (LON:DEB) and Ted Baker (LON:TED) so far. Some is clearly Brexit.
Hi Paul,
As I said I tend be less strict in my selling when there a market wide sell off. I let the dust settle for a few weeks then sell any that haven't recovered.
But you need to find a system that works for you.
Best of luck
Phil
Actually at one stage I had a strategy where I scanned the market looking for stocks exhibiting 5 bullish indicators. I'd then run them through Stockopedia filters.
I quickly learnt that it's much quicker to do it the other way around.
Hi Phil,
Oh my system works. But any system can be improved! I like having as many reference points as possible. And as I say, I really like this one.
And yes, waiting for the Brexit dust to settle (vehemently hoping it's Bremain)
Paul
Thanks for the kind words Randval.
Interesting alternative sell trigger you illustrate, but over quite a few years using the annual allowance I ended up with almost all my, & my wife's, shares in ISAs. This had its pluses and minuses, one being that you didn't have to work carefully to annual capital gains free limits (often swapping or gifting shares between us), and also until recently you couldn't include AIM shares - not sure whether that's a plus or a minus.
So deciding not to use stops was in my case a bad move!
Regards.
Prepare yourself for some extreme hypocrisy – after some bitter experience as a novice investor I think stop losses are a very good idea. The separate stockopedia article and comments on them is very good.
However, there are problems with using a stop loss with an event like Brexit. What if there is a no vote and the stock market believed we would stay in, it could badly gap/crash down on day. All your stops would be hit. Then buys would come in from people who were after cheap shares, the market could then dead cat bounce after your sells. Later in the day reason could prevail and market could make up most of its losses very rapidly. There are lots of possibilities and a stop loss would only be of any use if the permanent trend/fortune of the share/company was changed by this event.
Everybody knew it was coming so the thing to do was to take action long before June. Other such events are in October when the US markets decide what they think of the US and global economy. They can go start an upward trend but they can also crash. To confuse things there is also the general election in the US. The good thing is the market will have discounted what it thinks will mostly likely happen by the time of these events.
Have some cash ready to take advantage of any opportunities or to protect yourself.
On stop losses - remember that if a share has an extreme spread such as 5% and you set the stop loss to trigger from your buy price by 10% it will trigger when it is just 5% down.
If there is a tax advantage in selling a badly performing share then do so.
The trend is your friend – check what direction the share is going stop losses can protect you when the trend is down and you thought it was up.
Difficult to do but if the loss is triggered keep checking the share just in case that turn in the trend finally occurs.
The book by Stan Weinstein called Secrets for Profiting in Bull and Bear markets helped me as somebody who was taught Economic theory to get my head around basic technical analysis and the use of Moving Averages.
Acting more like a trader than an institutional investor is the way I am trying to go at the moment to improve my performance. Maybe, Stockopedia could employ a new service and have one of those ladies dressed in leather and a whip come around and smack my bottom and tell me to follow the trend and sell my losing shares. Then again I can’t afford it and if I could then I would not need the service! Reading Trading books and watching Trading DVDs and other such weirdness - might do the trick but then it is probably only slightly cheaper.
Yes, I wrote this rather selfishly to tell myself what to do and is not general advice for anybody else.
*Past performance is no indicator of future performance. Performance returns are based on hypothetical scenarios and do not represent an actual investment.
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Muckshifter - I think it's just my bad English and writing actually. I bash these articles out and don't proof read them enough... my touch typing is fast but sloppy. Apologies !
Thanks @crazycoops for the kind words... it's good to get some dialogue going on this subject.