Why I love the Stop Loss as part of my Investing Strategy
Firstly. I am not a very good writer, make plenty typos etc. My grammar is probably appalling and I was never good at English Lessons at school. But I hope I make some sense here..
I have been trading now for around 10 years with the past 8 years or so a modest success. My first two years was a disaster, with me losing around £15000. As a thirty year old that was a lot of money to lose. Far too much money. I was trading FOREX, penny shares, story stocks and pretty much going with the crowds.
But I didn't give up. I was fortunate in working offshore and having some disposable income that allowed me not to give up. But in doing so I realised that I must separate myself from the crowd and think deeply what I was doing wrong.
My turning point was reading Robbie Burns Naked Trader. This book has been my bible through thick and thin. It served me well and still does. But what was so special about this book than all the other books that I have read on investing? Well Robbie's book is the only book that taught me something very important. I was taught how to control losses. I was taught not only to have an exit plan on profitable companies, but also how to manage losses so they do not build up in a diversified portfolio.
But every time I try to promote the system that works for me on bulletin boards and even by the most respected successful investors; I feel that I am very much in a minority. I have struggled to understand why the majority of private investors are against using stop losses. But then I have realised that many investors follow the opinions of many successful investors who do not use them.
An important question often asked by professional private investors is..
'Why if a high quality, company with a strong cash flow, solid balance sheet, positive outlook share price goes down 10% - 15%, then should one sell up automatically? The fundamentals have not changed and thus we should use the dip as an opportunity to buy the same company on discount.
This is fair and perfectly understandable.
But here is my problem…
I am not as good as reading balance sheets, income and cash flow statements etc. In fact I am as bad as reading financial statements as I do writing little speeches as this one.
I do not have the eagle eye of highly respectable investors like Paul Scott. I do not fully understand Profit and earnings figures. In fact I am confused over the amount of adjustments and exceptional items that can scew the bottom line.
We have Earnings per share. Or is that Basic Earnings per Share, Diluted Earnings per Share, Adjusted Earnings Per share, Diluted adjusted … just gives me a sore head. I ain't going to mention the Price to Earnings Ratio! Is that based on forward earnings or reported.. and which version of earnings?
Worse still is the balance sheet. Depreciation of Capital Items or Amortisation of intangibles. Give the accountants their due, they earn their keep buy figuring all this stuff out.
Ok, so if I do not understand half this stuff then why am I making money. Why did I make money last year when most fell on a poor investing year?
Well I pretty much followed the Naked Trader strategy with some my own modifications to suit me. My check list is simple and I also use a spread sheet which helped my discipline and stick to my plans. Yes I have followed an investment plan and mostly kept to it.
Revenues – I just want to see that it has increased and likely to increase.
Profit – I still use pre-tax profit. What I am interested here is that it is growing or expected to grow. I use the 15x multiple to Market Cap.
Earnings – I usually just pick Basic Earnings Per Share and check that it is growing and likely to grow. I do not really care how this Earnings figure was achieved. Just pick any version of EPS as long as the growth comparison is the same version.
Net Debt – I still find the Net Debt figure and value this against Pre-Tax Profit. I do not look at how this Net debt figure is achieved.
Cash Flow – Now I care. I want to see a good cash flow and this in part diverts me from the Naked Trader. I want to see Free Cash Flow Per Share as being around or higher than Earnings Per Share. I use a very simple formula of taking Cash In Flow from Operations, deduct Capital expenditure and divide by number of shares. That's it. Is this way perfect or make sense? I have no idea but it works for me.
So with this method I simply want to see revenues, profits, earnings grow along with strong cash flow. I want to see net debt manageable or reducing.
Finally I want to read a positive outlook trading statement.
So as you can see with the criteria above, I will 'probably' miss lots of red flags that the professional investors would spot. So although the likelihood of using the above criteria should mean the share price will rise over long term, I still want to protect myself.
The stop loss is an important part of this. If the price goes down past normal volatility then I may be stopped out. This forces me to think about that investment. I ask the questions 'What did I miss?', 'Is there a major red flag I do not know about?'
The stop loss forces me to look further, research further. I'll certainly read Paul Scotts opinon if it is small cap. Find anything on the Financial Times, Twitter, Stockopedia, Google…..
If I find the red flag or anything negative then I am out and have been saved from losing more money. If I find nothing and decide this is just unusual volatility or a general market down turn then cool I will buy in. Yes I have to pay trading costs again and that is where this method may hit me hardest.
I hope I have made some sense and if you got this far then thanks for the time. If you agree with me or not I hope at least I have conveyed some argument as to why I love stop losses.
Just as final note, I do hope when professional and successful investors make their opinion known on stop losses that they consider the audience to which they make that opinion. If it is a bulliton board on ADVFN etc… maybe ask the question. Are the majority of posters on here as good as me? Or are they novices, learning about investing and until they gain confidence should have some arbitrary exit point when an investment goes wrong and they do not understand why?
I am now in the process of using Stockopedia StockRanks in a farming approach to help free up more of my time away from the Stock market. But as a stock picker I shall always use a stop loss in my strategy until I have 100% confidence in my farmings approach. The stop loss doesn't need to be too tight. Check the charts and place a stop loss out with normal volatility so your not stopped out in intraday spikes. The Naked Trader will explain how to do this.
Good luck everyone in their investing strategy.
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10 comments
I personally have not used stop losses in the past, selling instead on what I perceive to be a change in fundamentals. However this is difficult as @Grindertrader points out and could be an overconfidence bias on my behalf. For example a stock I currently hold; Murphy USA Inc (NYQ:MUSA) saw a big decline in revenue in this quarter's results and this caused a drop in the Sp, which has now hit my stop loss/re-evaluate level. I am currently in two minds over the sale, as despite the severe revenue decline EPS hit targets due to a different sales mix to the previous quarter.
Papers that evaluate the benefits of stop losses by simulating portfolio returns through a Random Walk Hypothesis, show a negative stop loss return premia - i.e. one would be better off by not having a stop loss strategy. This is because RW assumes a mean reverting return, so essentially you would be selling at the bottom, and would have done better holding the asset as it returned to the mean.See below for an example of a random walk.
Due to the conclusion above and the love financial literature has for the RWH as a return simulation, there has been limited research into the effectiveness of stop losses. Kaminski & Lo in their paper,"When do Stop Loss rules, Stop Losses?" however challenge this theory and discover that if the portfolio's return characteristic is driven by momentum or regime switching which are more empirically valid than RW, then you receive a positive stop loss premia. (They model a two asset portfolio, containing equity index futures and long term bond futures). Their model essentially avoids momentum on the downside and exploits flights to quality after large cumulative losses. It also crosses over to behavioral finance that one tends to sell winners too early and hold on to losers too long.
How this applies to an individual stock in one's portfolio is more difficult to quantify. It would be interesting if @Edward Croft could back test some common stop loss strategies with a basket of average stock rank stocks to see if a positive return premia is generated.
Robbie Burns does not have auto stop losses? Judging by his selling prices he sometimes sells before his stop loss or other shares have gone below his stop and he still holds.
Well auto stop losses have not worked for me, I had shares that have dipped down in thin trading, ie early morning, triggering a stop loss only to see the sp bounce back the same day. Also market makers use them to buy up cheap shares. Several of my holding have fallen 10-20% soon after I have bought them, most have recovered fairly quickly, some I have bought more shares, even large companies like AHT can fall 20%. STAF I bought at 600p they drifted down to 480p, if I had stop loss I would have sold, but I bought some more at 500p, they soon recovered and now are 1200p. I think you need to look at why the sp has fallen, if no reason then it canbe a buying opportunity. With my trades being quite small spread and dealing costs have quite an effect. So I now have no auto stop losses. Also if a shares crashes then stop losses don't work. If shares drift down then you can sell anyway?
Interesting thread I have been to one of Mr Burns seminars although i was already doing 90% of what he went through on the day the 10% I wasn't doing was most interesting.
Has anyone been to one of his follow up advanced seminars I'm thinking of going but would given they aren't cheap would be interested to hear from anyone who's been as to what their thoughts were.
Grindertrader, an excellent post and many thanks for sharing with us.
I guess we're of similar age, and I like you I've been investing for 10+ years. Also, like you I'm a fan of Robbie's approach, indeed went on a couple of his courses and pride myself on picking up on a few stocks some time before he did - but of course either sold too early or performance dragged down by buying some other speculative rubbish that glistened and sparkled and lured me in.
You make one of the most crucial points in investing - stop losses are crucial to performance, and knowing when to cut your losses and ride (and take) profits is the holy grail of investing.
You are so right when you comment that some famous stock pickers buy stocks and their holding period is 'forever', and the wider investment community latches on to that idea, and unfortunately it only holds true for a very few companies that grow to be huge. Most other (medium to large) companies trade within a range, having good years and bad years (many moving with the prevailing economic cycle) and the trick is to catch them at the right time.
Not every company becomes Coca Cola, or only a tiny amount of investors would have had the courage to buy Next at 10p (when all thought it would go bust) and watch it go to £70 in the next two-and-a-bit decades - I suspect most (if not all) would have sold out and congratulate themselves on a doubling of their money. I know I would have had.
Out of interest, do you operate trailing stop losses, or is the stop loss based on your original investment?
From my own experience, knowing when to take a profit or loss is the hardest thing to do - and a few things that serve me well are:
1) never be afraid to buy back a share, either above or below the price you last traded at. Some of my more successful investments were buying shares that originally I lost money on; either my original entry price was wrong, or more likely the company has sorted itself out and the fundamentals look far better than they did when I originally invested. But, don't fall in love with a stock of course...
2) Sell half on a double. At least you still have upside if that stock becomes a multi-bagger.
3) Don't invest in ultra-speculative stocks in any meaningful way. Sure if you want to have a gamble (because that's exactly what they are) then limit to a small % of your portfolio.
4) Stay clear of small cap oil & gas explorers and mining stocks. As many comment here, they are just vehicles to 'feather the nests' of their directors and advisers. It's unreal how many crooks there are on AIM; the market is regulated with such a light touch they might as well not bother, and if some are not crooked then they are just plain stupid and should not be running a plc.
5) Follow your gut. Most analysts fail to beat the market because they all follow each other and have a pack-like mentality.
6) Review past investment decisions. Last year would have been far better had I not succumbed to junior oils and miners - by far and away I've pretty much lost money on every single one. Why do I keep doing them? Because I was lucky enough to buy an oil company which multi-bagged and got taken over a few years back.
Apologies to anyone reading about the length of post - I certainly didn't want to come across as preachy, these are just a few things that have worked for me in the past, and really it's a list of ideals for me that, if I stick to, them maybe one day I'll become a skilled investor and consistently make more money than I lose.
I'm still learning every day and really enjoy reading stockopedia, especially the daily reports from the investment oracle that is Paul, the musings from David (and the wish that I could attend more of his gatherings than I do) and Ed's brilliant insights into the machinations of the stock market.
Cisk,
Thanks for taking the time to give a great explanation on how you also approach investing. I myself attended Robbie's Course around three years ago. What I wanted to learn from that day was just to watch and experience Robbie's style in trading and investing. I wanted to experience for myself and become satisfied that Robbie invested just like his methods in the books. Fair to say he does. I also enjoyed the level 2 training and from that afternoon training I learned just when level 2 has its uses, and of course when it is not.
I cannot put the points you have raised better myself.
Your point 1 is for me the most critical to master. I believe there is nothing wrong at all in selling at a small loss to buy in later. Timing I admit is still sometimes one of my weak points, but nevertheless I am always ok for buy back in.
Point 2 - Yes perfect. Once I am around 30 - 40% profit I decide to top slice, sell out completely or just hold it. I do not use trailing stops, as I prefer to know exactly where they are at all times, and thus manually placing stops works best for me. I do prefer widen the stop and become more relaxed once I am in comfortable paper profit.
I did write to Robbie last year asking about his stop loss rule when a particular share is well into profit. This was his reply
'Hi Ian..
Yes but the long-term winners are so far higher that stops don't really come into play much. On newer trades I definitely exit - you can always buy back lower!
cheers robbie'
So his strategy works well for me and I am more relaxed about stop losses when in profit.
Point 3 – I sometimes invest in speculative stocks but these are always short term and I must have a good excuse for it. For instance a trading update must say something like 'Profits and Earnings will be SIGNIFICALTY above market expectations' or 'The company is going through an amazing transformation'. Anything like that and I shall punt it, but always with a stop loss.
I have made money on QPP, GBO, COMS, BOOM, using this method while the crowds have followed too late, and now sitting on massive losses. None of these companies had strong fundamentals, but the punts worked for me.
Point 4 – I work in the Oil & Gas industry and fully understand many of the sectors from exploration, construction and production. In my honest view I find this industry too volatile to contemplate investing.
Point 5- Agreed. Notice how it is the quiet bulletin boards where many of the money making gems are. Strangely the crowd love a stock to spike 30% in a couple days, but do not seem to understand the stability of a stock that rises 30% over the course of a year.
6. Yes I always review my past investments, and especially when I get stopped out.
Also on Stockpedia, it is fantastic and something that I have longed for. I am gaining a lot of confidence in the StockRanks and is now part of my integral checks. Even after all my criteria has been matched on my old Naked Trader type check list I then look at the stock ranks. I still want to see high rankings. If not I will look further.
Talking of Paul Scott (if your reading this ;>). In my mind he is the best modern day private investor out there. I have the highest respect for him, probably more so than any other investor. I have never known anyone who spends so much time helping the private investor (for free!). While we are on the opposite sides of the discussion on Stop Losses. (I think Paul doesn't see any point in using them for long term investments), I admire and have learned a great deal from Paul. Yep I am a fan ! lol
I did fib a little bit in that I can now look into some balance sheet issues, and other red flags like level of debtors. But that is all down to Paul SCDR and his audioBOOM casts.
Not everyone may agree with him. I do not agree at times on a few matters however anyone who spends time insulting Paul and his opinions need to think deeply about themselves and their own investment style, if they got it wrong and blame Paul for their own losses etc.
Sorry for my ramblings too but I didn't expect to get going such a great responses. Maybe I am not a minority after all!
You are so right when you comment that some famous stock pickers buy stocks and their holding period is 'forever', and the wider investment community latches on to that idea, and unfortunately it only holds true for a very few companies that grow to be huge.
Peter Lynch favoured long-term holdings that could become the next McDonalds or Walmart. If you look at his book, though, nearly everything in there seems to have crashed and burned for one reason or another.
Greenblatt also warns that newspapers were once great businesses whose niches has declined. He himself said he had no confidence in spotting businesses that had enduring moats that would grow to be the next whatever.
My own thinking - and remember this is contingent and subject to change - is this: if you follow momentum strategies, then you buy, and hold so long as the momentum is intact. You need some kind of mechanism to help you determine when to bail out. A trailing stop-loss seems the logical choice to me. I think deteriorating fundamentals should also be used to sell, even if a stop-loss has not been triggered. In the CANSLIM strategy outlined in O'Neill's book, stoplosses are critical. He has said that you cannot just choose to ignore that part.
For much higher-quality companies, which are not rapid growers but are nevertheless good steady compounders, buying high is probably not a good idea. I think they're likely to be much more rangebound. There is also likely to be some uncertainty surrounding the stock required in order to buy in cheaply.
One example that springs to mind is London Stock Exchange (LON:LSE). I'm too lazy to look up my records, but IIRC i bought in 2012 when there were big worries about competition from other exchanges. It was trading on a price to free cashflow of 10, though. We are talking about a company with a history going back to 1801, with operating margins in the 40%+, trading at a PFCF of 10. Needless to say, I made money on that one.
Grindertrader- Your story is very much like mine. In my first 6 months I bought hyped shares and ended up losing quite a lot. However I also read naked trader and agree with you that it is a excellent book. It really opened my eyes to "sensible" trading. I have started to lose stop losses and find once my first one was triggered I am now use them without fear. I can see why some don't like them but they give me that all important security.
Hi Imran, thanks for the reply. I set stop losses on all my new investments via my broker Halifax. I also take a note of them on a spread sheet, so that I am aware of being close. I try to never let my loss exceed 20% on my initial investment on that share.
But once I am around 30% - 40% plus paper profit then I relax the stop loss rule and allow more breath, as l long as the outlook remains positive. Most my long term investments are boring stocks that move slowly so I have plenty time to think about it.
On my Spreadbetting, CFD leverage accounts a stop loss is mandatory no matter how much profit I am in.
I do not use trailing stops as I prefer to know exactly where they are placed.
Hi Grindertrader
Thanks for a great blog post, and I think a lot of private investors struggle with setting stoplosses. Do you set a stoploss with your broker, or do you simply make a note of this, and execute this manually?
Best wishes,
Imran.