What are your Golden Rules?
I published the below article on my website www.sharechap.com and have created some discussion, particularly around how prevalent the use of stop losses is around investors. I was inspired by Ben Hobson's article, published this week and quoted him at the start,
I'd be interested to see how much people use stop-losses people amongst our community and also what other Rules people live by when investing?
The risk of not having an exit plan is that you become a hostage to some destructive cognitive and emotional pressures. These unseen and sometimes instinctive influences can be a drag on your portfolio and may even make your best investments turn sour. Ben Hobson (Stockopedia)
Some years ago, I spent some time with one of the leading companies in a notoriously cyclical industry. This particular company had managed to consistently deliver market-beating returns, performing particularly well during a major downturn. I asked them what their secret was to beating the competition.
Their answer? We understand risk like none other in this industry.
The secret to big gains in any business is a mixture of luck (often right place right time) and the ability to take a bigger risk to deliver a bigger return. This company spent an inordinate amount of time analysing all of the risks of a project. Once they had done this, their greater understanding enabled them to enter projects that the competition would disminss as being “too risky” or “too expensive to enter” and they would make big returns. Their bigger returns would then be rolled into new projects where, adopting the same approach, their financial fire power would add an extra weapon to their armoury.
Investing in shares is a risky business. If you did not realise this, then investing is probably not for you. However remaining passive and doing little or nothing is also risky, due to the ravages of inflation. So we all need to take on a measure of risk in order to deliver a reasonable return on our money.
It is reputed that around 70% of investors in shares lose money over time. To the cautious, this would be hoisted as a big red flag as to why you should never invest in individual shares. I am more interested in why the 30% do make money in shares. What are they doing that the 70% aren’t, or failing to do?
In my view, there are three key aspects to making sure that you are in the 30% of investors who make money:
1. Buy decent quality growing companies never forgetting that Price is what you pay, Value is what you get (Warren Buffett).
2. Kill your losers decisively if the share price falls below a certain threshold below which you bought the shares.
3. Have a clear plan for your winners. That will usually involve running your winners as far as you can, but could also involve top-slicing (selling part along the journey), a trailing stop loss (so that you protect a decent portion of your gain if the price reverses) and a wholesale exit of the share if the mood music changes.
I call these my three Golden Rules. The truth is that I have only developed these recently following some both good and some bitter experience.
Each one of these three Golden Rules deserves greater examination and I will look to do this over the course of my blog.
For now, though I want to tell you a salutary tale. A tale where I abandoned my principles and lost money. I don’t get it wrong very often, but in this case I got it spectacularly wrong. I forgot the Rules.
I had some Indivior (Indivior (LON:INDV)) Shares after Reckitt Benckiser (a long term hold) sold off its Indivior business in late 2014. Indivior (LON:INDV) make opioid drugs and hold some valuable patents. I was given some shares as part of the RB sale and held them for a while before selling out for a profit when I got bored (a bad motive).
I carried on keeping an eye on them and noticed that not only had their share price risen very nicely since I’d sold, but they had good rating metrics on Stockopedia.
I decided to buy at £4.06 in January 2018 when I was buying groups of shares that met a certain criterion for my SIPP and holding them for a period without putting stop losses in place (I’ve very much now abandoned that “quant” strategy).
The share started well and rose to highs of £4.90 by June 2018. Although I generally look for more than a 20% gain and wouldn’t have sold, putting a stop loss at 10-15% behind this new high would have meant I would always have emerged with a profit (albeit a small one).
However, this was its zenith. From then on Indivior (LON:INDV) had bad luck with a court cases. In late June 2018 they dropped through the price I paid and fell to £3.64. I remained convinced they would rebound back to where I had bought them. After all they were “undervalued” when I bought them?
The truth is that whilst I could not have known all the bad news that was going to befall them, they were clearly not worth over £4. The Market marked them down savagely and I should have sold at this first warning in June 2018. As wise old stock market investors say, “bad news (or profit warnings) come in threes” and there were two further big markdowns in November 2018 and then in April 2019.
I finally sold out in August 2019 for 54p, nursing my heaviest ever loss and an 86% crash in value. Fortunately, my original position had not been that big…They now trade at just below 35p (as of 24 January 2020).
Although I had obeyed Rule #1 by buying what seemed to be a good quality company, I had disobeyed Rule#2 which was to kill your losers quickly and decisively. Rule #3 was also ignored as a trailing stop loss would have made sure that I would have emerged with some profit. I had a plan (buying a basket of shares and not having stop losses) but it was a bad strategy.
I would not allow another Indivior (LON:INDV) to destroy wealth in my portfolio. I learned that news comes in clumps and poor performing shares suffer downwards momentum. How could they be worth less than a tenth of what I paid for them? The truth is that is what the Market is saying today.
It is also poor logic to wait for a share to recover back to the price you paid for it. That price is only significant to one person (you) and is the classic psychological mistake of “anchoring”. This is worthy of a whole post in itself. A share that you bought for £1 falls to 80p (a 20% drop). Did you realise that it has to gain by 25% in order to get back to where you bought it? Much better to get rid and select a better share next time.
Learning from your mistakes makes you a better person in life and certainly a better investor. Never forget that.
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26 comments
Hi Sharechap.
Not sure if you’re still out there, but wondered if the turnaround apparent in Indivior (LON:INDV) over the past year or so (share price now back up to 243p after a further strong set of results reported) changes your view? Was Indivior (LON:INDV) a decent company after all (despite the severe buffeting from the US litigation/patent dispute) that now seems to be mean reverting to a decent share price/valuation? Cutting losses/use of stop losses makes sense if it’s implemented consistently and timely but having already swallowed a very large proportionate loss is it worth running the option value of a bombed out company that you previously rated as having “Quality” a strategy worth considering?
Gus.
These are the rules I follow and I recommend, in order of importance.
A bit off topic but I have been watching Naked Wines (LON:WINE) with interest. This is now a lean, cash rich, online business that is expanding into the Direct to Wine market in the US. It is already an established brand in the US with a proven marketing strategy and excellent customer returns of 4x investment in acquisition. Customer retention is over 80%.
What really draws attention are the respected investors taking stakes. Check the TR-1's.
I'd welcome any thoughts from more experienced investors.
It has been a share I’ve generally avoided as when it traded as Majestic it rarely came anywhere near the key points I needed to hit to consider investing. Your comment has tweaked my interest again and yet it still presents badly on the Stocko analysis. Other than interesting people taking stakes what is the investment case on the metrics?
sharechap, what’s your view on £indv now? Cash less debt seems to be close to mkt cap, do you think all bad news is in the price?
Much of what you say makes good sense. However I would add never turn your back on past losers. In many cases the original rational for buying a stock can still hold, yet price has been punished.
Thanks Cisk. Yes INDV has grown quite well since I wrote about it!It probably falls into the trap of being one of those stocks that has been badly beaten up and may not reflect true value. I've decided not to become a bottom fisher as I've been burnt on a few occasions by the volatility of such stocks. I haven't got the bandwidth to research these kind of stocks and if they are still being heavily shorted then it could be a battle.
I tend not to go back to past losers as there are many fish in the sea. I would only make an exception if I saw a really good turnaround story emerging. For example I watched PETS for a while after IPO (it bubbled and sank), but didn't hold it until I was convinced about the story. It's been one of my best recent performers.
INDV down -18% today: https://uk.advfn.com/stock-market/london/indivior-INDV/share-news/Indivior-PLC-Final-Results/81743063
a lot of stoplosses are placed around resistance and support lines, if you place buy orders at those levels and do the opposite of the obvious stoplosses youll probably make money, in fact I'm sure of it
there's no substitute for daily vigilance and experience when it comes to knowing when to sell, even then youll get it wrong sometimes
To present a contrary view... I think that stop losses feed shorters. They know that if a share price goes down 20% a whole bunch of private investors who use stop losses will sell... then the shorters close at a profit. I don't think stop losses are plausible to use on small cap shares and certainly not in the melee which is AIM. If a share has gone down x% then it is cheaper and so better value if you have assessed it's value or long term potential correctly. Sure, a drop is a significant reason to reevaluate whether you are correct, often it means you have missed something and might want to run for the hills, and yes momentum is very real. But selling due only to a stop loss is selling because you assume there is something that you are missing or have not understood without actually knowing what it might be...
Here is some support for this view.
Personally I don't generally use stop-losses, because for the type of diversified portfolio I run together with holding criteria, they actually provide a drag on performance.
However, what I do do these days is use price-drop alerts to trigger a re-asssassement of a holding. As you say, "If a share has gone down x% then it is cheaper" but as you also say it is worth a re-evaluation.
It is easy to dismiss price declines as just market noise, punters getting bored by lack of news; however sustained price declines can be indicative of the fact that other market participants may have spotted something you haven't. This may not effect the long term value of your holding, but might be a short term warning.
Two examples that I failed to heed have reinforced my view that I need to concentrate on this.
A.G.Barr (LON:BAG) the share price ticked down 10% between the start of June last year and mid-July - that's neither a particularly profound movement or over a particularly extended period, however taken in context of a share-price that was only going up, it was noteworthy.
16-Jul they issued a profits warning causing a near 30% price fall. The main reasons - poor weather & challenges on a particular product range. Both of these were potentially knowable to those who follow the sector closely.
The second example is perhaps a bit more profound.
Zotefoams (LON:ZTF) Between May & October the share price drifted down by c. 20%. The chart for Zotefoams can be a bit like a staircase , with strong moves up on updates and a gentle drift in between, but this was somewhat outside the norm.
3rd October a trading update causing a 40% fall - previously signalled economic weakness in Europe impacting demand for polyolefin foam had worsened. The price decline over the prior months perhaps indicated that market participants with a clearer view than mine of the precise markets served by Zotefoams had spotted this. Even without the industry knowledge the European slowdown should have given some cause for concern.
It's early days to see whether I can really improve my performance by rigorously applying price-drop reviews (and because of the degree of subjectivity I cannot back test it) but I am certainly hopeful.
But in either case I want to see the MACD above the signal line.
For me, there are many variables and I dont believe there is a right or wrong way - Although I would say the process needs to be aligned with your personality and lifestyle.
I have a busy life in general so day trading 'hourly' charts or even daily charts is not for me.
I also like understanding fundamentals etc which alone puts me into a medium/longer term view.
I'm a very avid advocate of stop losses, but there needs to be a tangible reason for placing stops - So I look at the structure of the markets to consider such placements.
As such I'm a fundamental and technical analyst - Which from me is the sweet spot.
I keep it simple, good fundamentals weighted towards quality factors, a positive trend (I only trade when the weekly MACD is above the signal line)
The initial stop is placed based on the structure of the market, whether that is under a recent pull back, or a consolidation level - If there is no structure there is no investment because there is no measure of risk.
I exit based on the weekly MACD crossing below signal line with an eye on the most recent candlestick.
This keeps the process less subjective and mechanical.
Works well for me, but as I say, thats just me.
That's interesting- I like your technical approach. MACD weekly is not something I've habitually done.
How much weight/interpretation do you place on '...the most recent candlestick.' Thanks.
I wait for the close of the week to determine if the weekly MACD has crossed below - My stop would be placed marginally below the tail of the closing weekly candle. I do this religiously.
If price recovers without touching my stop I will keep raising the stop each week below the closing tail of the candle until the MACD crosses back above, I will then not touch the stop until the MACD crosses down again, I repeat the process thereafter.
Because its based on a weekly time frame its easy to manage.
Thanks for that. Manageable, as it's weekly, clear and disciplined!
gpacker, could I ask, do you buy the stock only when it's breached the consolidation resistance level? Thanks.
Hi Farmer,
Yes if its a consolidation pattern (weekly chart), I would wait for the weekly candle to close above any resistance level, with some reasonable volume. I place a buy order slightly above the close of that candle and allow for the following week for it to be taken.
My immediate stop is generally placed slightly below the wick of that breakout candle.
In my experience, the weekly chart structures are more reliable than the daily, therefore the frequency of being whipsawed out is less.
My average loss is around 6%, but my initial stop loss is normally between 8 - 12 %, anything greater and you will struggle to recover assymetrically.
IMHO :-)
Hi gpacker,
Thanks for that, and the numbers you provide are interesting. Yes, the story of my investing life is trying to recover asymmetrically. Could I ask, how do you decide if there is a pullback - reliance on TA again? Thanks.
Slightly more subjective TA, but usually based on a moving average that it has adhered to in the past, but I want to see a slight recovery from the pull back in order for it to create the structure for a stop. I never predict the length of pull back, I react to it, and if this is around or ideally a bounce off the MA, then great.
Thanks gpacker.
Interesting article. Thanks.
You suggest that 70% of investors in shares lose money over time. Where do you get these figures from? Are you referring to spread bettors or novice retail investors? Overall the markets return around 10% and you have to be cognitively challenged (or Neil Woodford) to underperform the markets consistently over time. (Spread betting is another matter, I accept, and the figures do. confirm around a 70% loser rate overall.
With regard to stop losses, there will never be unanimity. There are those that use them, and those that don't. Traders and speculators probably do need them. Buy-and-holders probably do not. My reasons for not using them are that they're useless when shares gap down dramatically (like Indivior) and that I like to think I've enough self-discipline to sell an obvious loser (I sold my Plus500 (LON:PLUS) three days after buying them at a 30% loss, which was painful, but better than the 60% loss I'd have suffered if I'd hung on to them). I'd also argue that shares need time and space to grow and selling something that's dropped 25% can prove a costly mistake a few months later (I sold Persimmon (LON:PSN) at £19 in August and now, 5 months later, they're >£30 ).
We can use anecdotes to justify ourselves, but this can lead us into the cognitive error of 'Sample Size Neglect' which is elegantly described by Amos Tversky and Daniel Kahneman. (https://www.investopedia.com/t...)
My safety net consists of time and diversification. My selling decisions merely add to my costs and add little value to my portfolio.
The 70% comes from Robbie Burns's book Trade like a Shark (2016). It relates to normal traders/investors. He also say s that 95% of day traders lose money over time. He doesn't attribute the research but did express some surprise at the figure.
I guess that my philosophy has been developed partly by The Art of Execution by Lee Freeman-Shore (2015) where the best fund managers were those who controlled losses well and ran their winners. My point is that the key to delivering long term returns is controlling your losses coupled with running your big winners. I'm a big fan of Leon Boros who spoke very well on this at Mello in 2018.
Thanks for the clarification. Yes, there is evidence that the vast majority (90+%) of day traders loses money (if one excludes high frequency trading to which most of us don't have access). Equally I'd accept that short term amateur traders looking for profits in a 3-6 month time scale are more likely than not to make a loss. But I think it's a mistake to put investors and traders in the same bracket. The strategies are entirely different, as, I suspect, are the results. Whilst I enjoy reading Robbie Burns' books, I'd never accuse him of academic rigour. Generalisations need to be supported with at least a modicum of research.
If you flip a coin three times, your probability of getting three heads in a row is just under 13% (50%*50%*50%)
For professional money managers, studies over time suggest only 25-30% outperform their benchmarks for any three successive year period. These are the ones who either have some skill or who got lucky.
As you point out, it's important to know the sample size. In the US there are more than 9500 mutual funds, so in the average three year period around 2500 of them will outperform their benchmark three years in a row. These are the Fund Managers who will be visibly in public explaining what their golden rules are. Ofen though, they are no more than lucky coin flippers.
https://www.cnbc.com/2017/02/2...