Why Losses Ruin Your Returns

Friday, Mar 15 2019 by
11

Managing risk and cutting losses can have a significant positive effect on your portfolio returns.  Also below is why tracking your trading results is key to successfully managing risk.

Firstly, hopefully the table above is an eye opener for how losses work geometrically against you - i.e., the more you lose the more required to get back to even.

5c8c258dad00eLoses.png

Below is a table showing example trading results and the difference between managing risk (keeping losses small) and not managing risk.  The difference is world class performance (+209%) vs losing 62% of your portfolio value.

  • The starting values are exactly the same, £100,000.
  • The number of trades is exactly the same, 24.
  • The ratio of winning trades vs losing trades is exactly the same, 50/50.
  • The gains on winning trades are exactly the same.
  • The only difference is one set of results caps losing trades at 10%, whilst the other set of results increases each losing trade by 3% (starting from 5%).

At the end of 24 trades one person has managed to lose 62% of the value of their portfolio and is left with £37,775 from their starting £100,000.  The other person has achieved a 209% return and now has £308,887.  In other words, in the space of 24 trades by managing risk, one person is up £271,112 over the other.

Remember how losses work geometrically against you?  The person who lost money now needs to make back circa 2.65 times his £37k just to get back to even.

5c8c25a3c0a64GainsVLosses.png

Below is the Kelly Criterion to help you further understand your own returns and your optimal position sizing based on your actual returns.

5c8c25e9562bcKellyFormula.png

As shown in the Kelly Criterion table above, by keeping losses small comparatively to gains a speculator can achieve high returns even being wrong half the time - 50/50 win loss ratio.

In the above example the Kelly Criterion is showing, based on actual results, the speculators optimal position size would be 25.91%.  This might seem too high, especially when trying to manage risk, so many successful speculators in this situation would apply a half Kelly position - i.e., circa 12.5% of the total portfolio value.  However, most would scale into positions so the first position they take might be quarter Kelly.

Cheers,

JC

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Disclaimer:  

All information is for Educational purposes only. It is not to be taken as buy or sell decisions or financial advice.

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28 Posts on this Thread show/hide all

jonesj 16th Mar 9 of 28
2

This is not a realistic calculation and should not be presented as a mathematical justification for stop losses..

It is not using real share price history data. This takes no account of stocks which fall by 10 or more percent then multi bag.

For example: If you bought Amazon stock in 1998, with a 10% stop loss, you would have sold it every single year up to and including 2016, therefore missing out on huge returns. [My data source does not include 2017, 2018, 2019]

The opening analysis is severely over simplified and it is nowhere near that easy to formulate investing strategy.

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mmarkkj777 16th Mar 10 of 28
2

In reply to post #458683

Hi JonesJ.
Your amazon example doesn’t really ring true. For someone to have sold amazon every single year, they would have to have bought every single year, so they may not have missed out on large gains. It would depend on the timing of their purchases too.

note. I’m am a long term, but not continuous,, Amazon holder.

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wilkonz 17th Mar 11 of 28
1

Peter Lynch in 'One Up on Wall Street' advises against using stop losses. I guess what he means - although he doesn't say so explicitly is 'If you're buying a stock that needs a stop loss, don't buy it'. This advice clearly applies to buy-and-hold investors rather than traders who make their money out of volatility and trends. These days I only use stop losses when I'm spread betting (a pastime at which my losses slightly outweigh my gains). If I think a stock needs a stop loss, I don't buy it. It concentrates the mind - like being a tight rope walker without a safety net.

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Gromley 17th Mar 12 of 28
7

It is important to recognise , even though not explicit in the original article, that JC is talking about short term trades, where the case for using stop-losses is certainly stronger than for a longer term investment outlook.

However, I don’t believe that this article makes that case even for short term trades.

The sequence of trades shown is highly misleading imho.

It’s not clear whether the 24 trades showing the difference between loosing 38% without using stop-losses or gaining 209% using stop losses is a fictitious or real set of trades. Even if it is a real set of trades, no evidence is provided that this is representative of what will happen on average – it is a very small sample of 24 trades (and only 10 instances of a 10% stop loss being triggered).

What stands out to me (and suggests that data is “engineered”) is that in this 24 trades, there is not one single instance of a stock falling by 10% and then recovering.

Is it an axiom of the market that if a stock falls by 10% it will not recover?
I think not.

Take for example trade number 4, which lost 8% - it is highly convenient (for the purposes of demonstrating the value of stop losses) that the trade was closed, for whatever reason, at the very low point and never breeched losing 10% and then recovering.

But it is not just that data point that is suspect potentially all of them are. JC clarifies that he’s representing a typical holding period of 4-20 weeks – is it conceivable that a sample of stocks that appreciate by up to 39% over that period and have an average movement (in either direction) of 23% has no stocks whatever that fall by 10% only to recover?

Again I think not.

When considering stop-losses one has to consider their potential downside, which is that they can stop you out of positions at or near a low point which would have come good had you ridden out the movement. The figures above appear to assume that never happens.

I personally do not routinely  use stop losse,s as all of the research I have done demonstrates that they are counter-productive for my style of investing. Even when doing ‘short term trades’ I take a judgement on whether to close a position rather than using a mechanical stop loss (and even then I have found that on average I close positions that would have been better left open.)

This is not to say that I discount the use of stop losses completely, but I think one needs to consider them in the specific context of one’s own investments rather than take given rule – say 10% as Gospel. (I am also tempted – although I have yet to investigate – that the suggestion of setting a stop loss relative to an individual stocks volatility may have merit.)

So if you are considering using stop losses I think it is vitally important to consider their impact on your personal ‘style of trading’ and whether they will add or detract to your returns

DYOR does not just apply to stock selection.
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mmarkkj777 17th Mar 13 of 28
8

In reply to post #458733

Hi Wilkonz,

While Peter Lynch (and others) advises against stops, many other notable masters advocate stops (Mark Minervini, etc), so I don't think there is a clear cut case.

If, when buying a stock I could be absolutely 100% sure it would only ever go up I would put my house on it, without a stop. Unfortunately, such a stock doesn't exist.

Having come from a value/long term/ buy and hold fundamental approach, I do know what he means and why he said it.

I have held many long term stock with no stops, but I will use them now for almost all my stocks. Why not? It saves a big fall, and if its only a smallish fall, say 14/18%, which then recovers, I can always buy back in when it starts to recover.  Sometimes Black swan events come along and a stop protects somewhat from this, even allowing for slippage if it gaps down (I sometimes have 2 stops in place to reduce the risk of the first being missed)

Just my view. I know this debate will always go on with valid points on both sides.

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wilkonz 17th Mar 14 of 28
1

Hi Mark,
Thanks. Agreed. The debate will certainly go on. There is no answer that is absolutely right for any given situation. If I were a trader like Jack I would use them routinely and I do use them routinely for spreads. With regard to my 'buy-and-holds' there is usually enough time to make a rational decision about selling without help from a stop loss. And if prices fall very fast, like when they gap down overnight, a stop loss is subject to slippage. These days I try to be more influenced by a change in the metrics or management rather than price fluctuations (except of course when blind panic takes over as it did in late 2018...)
William

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mmarkkj777 17th Mar 15 of 28
2

In reply to post #458758

Hi william,

Agreed. I have recently been reading Mark Minervini (and other notable traders) and now trade with around a third of my invested capital (stock related capital, that is), the others 2/3s in longer term share investments. So this may be why I am now sold on the concept of stops. 

If someone doesn't want a stop to be triggered accidentally (e.g. for a buy and hold stock), it is possible to have a trailing stop well below the price and unaffected by normal volatility (say even 20-25% below) acting as a kind of insurance against a disaster. I like this, even if it is just a mental placebo crutch, as it allows me to go and play golf with some peace of mind. having a pre-set worst-case scenario  in place that wont completely wipe me out :-) .

Joking aside, there is a lot to be said for the confidence that a stop can provide by limiting the downside.

Gromley and I have debated this stop/no stop topic before.

I'd love to see a Stocko Article on the merits or otherwise of stops (maybe with backtesting. Difficult I know).

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wildshot 17th Mar 16 of 28
2

In reply to post #458683

I've traded Amazon twice over the years and twice come out down with a stop loss. I really regret having stop losses on those trades because I would be notably richer now if I held and believe in the stock. To some extent I did believe in the stock but I was using a stop loss strategy at the time and from my history I can see that it led to overtrading and missed opportunities on the bounce back of shares.

Now if a share falls in price, I try to find the reason why and re-evaluate the share. I then make a call whether to hold/buy more/sell. Some recent examples are St Ives which fell sharply a few years ago, I assessed it was no longer a good story so got out at a marginal profit. Then I held and still do £MRCO. It fell significantly in one sudden movement to below £10. It happened rapidly one morning when I didn't have time to react or read the news before c.9:30am. I assessed the stock and decided to hold, with a view to topping up when funds allowed. Now, in less than c.12 months it is up to c.£19.

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wilkonz 18th Mar 17 of 28

In reply to post #458763

Yes Mark, a Stocko Article on stops would be a great idea.- the subject is fascinating and far more complex than it appears on the surface..

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wilkonz 18th Mar 18 of 28
1

In reply to post #458818

Quite so Wildshot. I've been stopped out of good trades by large and irrational intraday price swings of 5-10% that have only lasted a few minutes. Hence my reservations.

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uktim32 18th Mar 19 of 28

NAPS 2018

It would be fascinating to know though how the NAPS would have performed last year (and all years) with say a 10 or 15% stop loss?

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mmarkkj777 18th Mar 20 of 28
1

In reply to post #458843

Hi Wilkonz and Wildshot,

Yea, me too.

I don’t disagree that being stopped out of a share that then immediately recovers is frustrating, but with this you always have the option to buy back in.

If a share tanks while you are otherwise predisposed and you don’t have a stop, then that’s it. You don’t get to reinvest the lost capital. In time, the stock may recover, but it might not. There have been several recent examples of this. It also happened to me on a US stock where I can’t use stops with my broker.

Pros and cons I guess are different for different people with different styles and circumstances.

Let’s have some proper Stocko analysis. Can it even be done?

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unwise2 18th Mar 21 of 28
2

If you are a fundamental based investor only and ignore the chart when timing buys you are going to get chopped to pieces. For a stop loss strategy to work well you need to learn to time you buys. The three best known base traders all used stop losses, Mark Minervini 10% max, O'neal 8% max and Weinstein 15% max.

These stop losses are all initial stop losses, once the stock is showing a profit the stop can be widened to allow for more volatility if you want to hold longer term.

If you don't have a stop loss when do you sell a losing position? Most fundamental investors would answer if the story changes. Unfortunately by the time a company officially admits a problem exists the share price has often tanked already.

I learnt the above lesson the hard way and the fees were high.  


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Ramridge 18th Mar 22 of 28
5

I follow Minervini's method pretty closely (but not religiously). One rule that I am very strong on is to sell losers at max. -10% mark and let winners run. I start thinking of cashing in winners at +18%. This method has transformed my returns significantly, besides giving me a good night's sleep knowing that I am not sitting on a big loss making share.
However for a long time, the big unknown to me was whether I was leaving money on the table. Because I keep details of every trade and have been doing so for over two years, I did an analysis of all shares where I cut my losses, and followed their SP movements 3 months, 6 months and 9 months after the sell dates. The conclusions were:
- my average cut off point was closer to -7% than -10% . Never more than -10%
- the net gain/ loss for these shares in the period after selling them, was near zero for each of the three periods considered.
- there were major peaks and troughs. Some of the shares went on to perform spectacularly and others just continued to sink badly. But the net theoretical profit/ loss was near zero.

Now I no longer worry about 'what might have been'. The winners more than compensate the losses.

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Nick Ray 18th Mar 23 of 28
1

In reply to post #458853

It would be fascinating to know though how the NAPS would have performed last year (and all years) with say a 10 or 15% stop loss?

Last year with a 10% stop loss 10 stocks ended the year below -10% but 14 stocks would have been stopped out. If you had continued to hold NAPS2018 into 2019, PLUS would also now be stopped out.

stock% returnstopped out?
INDV-71.7stopped
TW.-34.2stopped
VOD-33.7stopped
GFM-28.1stopped
MGNS-26.7stopped
STHR-26.5stopped
RPC-24.4stopped
FORT-24.3stopped
STCK-22.1stopped
LSL-20stopped
SCS-4.57
JEL-4.21
TATE-3.62stopped
BP.-1.97stopped
SND1.16stopped
VTC2.16
OCN4
BMY6.13stopped
VLE15.5
PLUS56.8
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Jcorsellis 18th Mar 24 of 28
5c8f9642de185gains.png

The table is from Mark's book.  I'll save you working the figures out... It's a total return for the year, exc divi's, of +189%.  This is with a 46.32% winning percentage and a largest single gain of 30.04%.  I don't get how anyone can argue the other side of this.

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andrewdb 18th Mar 25 of 28
2

Stop losses will work to some extent as momentum effects are real.
I.e. in the short term a stock that is falling will (all things being equal) continue to fall for a while.

One substitute for a stop loss may be to not buy stocks with negative momentum.

I do keep a stop loss relative to the ftas for the first 2 months if it falls more than 15% compared to the ftas I start to ask why ... ... but not actually sell.

I had a stop loss triggered on amzn...  ... and sold.  Big mistake.



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dmjram 18th Mar 26 of 28
5

In reply to post #459068

The disagreement stems from the differing natures of buyers/sellers in the stock market.

For short term swing traders like Mark and followers of the CANSLIM method such as David Ryan, stops are a central and essential part of the process.

For others such as the likes of Buffett and his followers with much longer holding periods, the short term price movement of a stock isn't a concern - what is the difference between what Mr Market values the stock at and what the intrinsic value is. It can take years for the market to adjust its view.

Note that for individuals, swing trading while delivering great potential returns over a relatively short period is also very time intensive. Hence many do their fundamental analysis, develop a view and stick with a stock until fundamentals change, they can't/won't sit at the screen reviewing price action day in, day out.

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Snoo 18th Mar 27 of 28
1

In reply to post #459068

Isn't that because different people will be using different philosophies for investing?

It's a bit like claiming that Warren Buffett does not use stop losses and has terrific results, therefore everyone should not be using them. Of course it depends on what you are doing.

I don't operate with stop losses any more - although that does not mean I will HODL on anything that has lost 15%, I could easily sell out, do nothing or buy more. It depends.

Some of the very worst losses you suffer occur whether you have a stop loss or not, as you won't get the chance to trade out.

As Buffett says stop losses are a protection against volatility, not risk. And we can mitigate risk to a degree by diversification.

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GUYUKTRADER 18th Mar 28 of 28
3

I am a short-term momentum and breakout trader (4-8 weeks on average - winning stocks as long as I can).

I live by stop losses as I am looking for relatively quick gains so stop-losses saves me large losses and wasted time in the market when a trade goes sideways or down. I am also completely out of the market for periods of time if the market is weak/dropping.

I get the impression from reading some of the comments that a stock is almost discarded when it SL's and one can lose the potential gain if it rebounds. For me there is no connection as I buy back on many occasions a Stock which I have sold as a result of a SL but re-shows technical strength. There are many examples of the same stocks I have sold out and re-bought based on my technical trading system.

Back testing all my trades in 2018 recently I would be a losing position without a SL - not just through losses but also through time wasting on stocks that meander for months.

However, for long time buy and hold/ dividend or value investors SL is probably pointless and best to follow the stocks fundamentals and/or selling if dividend is cut.

Guy

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