Why Losses Ruin Your Returns

15th Mar '19 by Jack Corsellis

28 comments 4613 reads

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.

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.

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

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,

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Nick Ray

16th Mar '19

There's a major flaw in your demonstration that limiting losses to -10% results in dramatically better returns: you have not changed the upside returns at all. So you have assumed that if you simply move your stop-loss to -10% it will not also turn some of the positive trades into -10% losses.

If a -10% stop-loss worked in the way used in the demo, then a -5% stop-loss would be even better, and a 0% stop loss would be the best of all! Why not just sell any stock as soon as it moves in the wrong direction?

The answer of course is that stocks do move down as well as up and what matters is that the long-term direction is upwards and the downward excursions are proportionate. These two ideas are captured in the mean return and the volatility.

From a geometric point of view, a loss of -20% is the same magnitude as a gain of 25%. You can actually benefit from this by rebalancing regularly which results in what is called "volatility harvesting" and in effect it returns the arithmetic sum of the geometric pairs. And of course (-20%) + (+25%) is +5%. (In general the benefit is 1/2 σ² where σ is the volatility.)

whitmad

Much thinking of the impact of loss vs gain is fixated on the percentage representation of change in position. Think instead of the ratio of values in vulgar fractions and you get a clearer idea of the relationship. A 10% loss is a reduction in value to 9/10 the previous value, to recover the position requires a an increase to 10/9 of the lower value. Thinking in percentage terms creates an artificial asymmetry.

What really matters is the likelihood of that recovery taking place. If the fundamentals of an investment are sound, then if it falls to 1/2 of its previous value, the fundamentals are still sound and the prospects of recovery are good. If the fundamentals change, e.g. a profit warning, then the prospects are poor.

In the analyses I have performed of my own portfolio history I have been unable to find any level of stop loss that would not have cost more through forced sale of investments that later recovered than saved in preventing subsequent losses.

This is particularly true in the small-mid cap space where liquidity effects can move prices up and down by significant fractions in the absence of any news or change in fundamentals.

Disclosure: I never use stop losses.

Jack Corsellis

You've missed my point, and we probably have different strategies for speculating in the markets. I am focused on breakouts and from your wording you seem more of a value investor or longer term holder. We inherently would disagree because from a value standpoint the 'cheaper' something becomes the more you should buy.

If a stock moves 10% against you then your entry timing is poor. How do you know when a stock has moved 10% against you it will turn around and be positive? You don't. Even if the stock has been in a clearly defined uptrend for months or years. Therefore, the point is that your entry timing should be good enough that a stock does not move 10% against you and if it does you cut your losses immediately. In keeping with what my role model Jesse Livermore said to do.

The idea of the post was to show that holding onto large losses in your portfolio is detrimental to returns. Further, if a stock has moved against you in price why not find a better candidate and admit you were wrong? What does it matter if you make 10%, 20%, 30% return in Stock A or Stock B; other than your ego.

Like I say though it comes back to your strategy. My average holding period is 4 - 20 weeks not 1 - 10 years.

I understand the point you're making regarding fundamentals. However, you say if the fundamentals are still sound and the prospects of a recovery are good. Often times the price has already moved to account for new fundamentals, positive or negative, which are not yet known to the 'public'.

This isn't my opinion it's the workings of Richard Wyckoff. Here's a great article on the Wyckoff Method.

The calculations in the 50% win/loss table can be put in any order and still finish with the same end result.

The point is to cut losses as soon as they start moving against you.

Below I've used the same figures but just changed the order.

Trigger14

I’ve seen this sort of argument many times before, It is one of my pet peeves because it is nonsense, effectively for the reasons mentioned in the previous responses. There is no inherent ‘mathematical’ benefit to cutting losses. Cutting losses quickly will stop you having bigger losses but it will also lose you a lot of your winners (the ones that bounce back after falling a little). As Nick Ray says the example doesn’t account for this.

The more common fallacy is around the geometric nature of returns. The argument goes something like: because of the mathematics of compounding, the more you lose the harder it is to get back to break-even. If you lose 20% on an investment, you will have to earn 25% to get back to break even again. If you lose 50%, you need to earn 100% etc. Therefore you should cut your losses when they are smaller and easier to get back from, for example by using a stop loss.

This line of argument is illogical. It is true that the compounding of returns means that your investment should make geometric rather than linear progress (whether increasing or decreasing in value). However, this doesn’t dictate whether should stick with your current losing investment or switch to another. The reasoning commits the sunk cost fallacy – costs that have already been incurred should not affect your current decisions. Investment losses are ‘sunk’ (already lost) whether you continue to hold your current position, or decide to sell and reinvest the proceeds in another investment. You don’t get to magically erase your loss and start again by selling your position. Either way you need to earn a higher percentage than you lost on what you have left to get back to break-even. Cutting a loser is only a benefit if the investment you reinvest the proceeds into goes on to perform better than the one you cut.

The logical rationale for cutting losers quickly and running winners would have to be because winners tend to continue to do well and losers tend to continue to do badly. It is about exploiting momentum. Tight stop losses is a strategy that may work, but because of a market inefficiency (momentum) not a mathematical gimmick.

mmarkkj777

Hi Whitmad,

Regarding your analysis on your own portfolio Re:

"In the analyses I have performed of my own portfolio history I have been unable to find any level of stop loss that would not have cost more through forced sale of investments that later recovered than saved in preventing subsequent losses"

The problem with this is it is impossible to make a true comparison this way as there is no way of knowing what you would have done with the cash from the sale (triggered by the stop) and how well the reallocated assets would have performed in another stock with a more positive momentum.

All I know is my own personal performance has increased since I started using closer stops (6-12% trailing). What I don't know is if this is the only reason, or are other factors (e.g. experience, knowledge, market factors, stockopedia) also at play over this period. Its impossible to trade in a sound proof petri dish to have a competely true comparison.

BTW, by stops I'm taliking about automated and manual stops. Anything with a fixed sell price limit that compares favourably with my profit target.

skinner66

i didn't stick to stop losses, until i read naked traders book .{robbie burns} he sticks to 10% loss and says dont fall in love with a stock,, he has made it so you follow successful people, as he says you can get out of stock then get back in when falls a lot lower so saving losses { if stock is worth getting back into }, between getting out and buying back in, but everyone has there own ideas which i respect,,

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Jack Corsellis

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