Why stop losses might take the sting out of selling losing shares

Monday, May 09 2016 by
Why stop losses might take the sting out of selling losing shares

There’s a maxim in investing that you should cut your losers and run your winners. But the problem is that individual investors tend to do the opposite. Research shows that profitable stocks are often sold too soon, while losing stocks are held too long (in the hope they’ll recover) - and that damages returns. It’s a behavioural bias so well known that it has its own name - the disposition effect. The good news is that the humble ‘stop loss’ could be one way of avoiding this particular emotional trap.

What we know about selling losers

Joel Greenblatt tackles the issue of selling shares in his book, You Can Be a Stock Market Genius. In typical forthright style, he says: “The bad news is that selling actually makes buying look easy… however, here’s a tip that has worked well for me: Trade the bad ones, invest in the good ones.”

Greenblatt stresses that this advice isn’t quite as useless as it might seem! His point is to know the kind of company you’re buying and hold it for as long as it performs as you expect. That might mean cashing out early from shares that suddenly face an uncertain future. But other positions might be held for many years. The logical conclusion is that you should sell badly performing positions as soon as possible.

Greenblatt’s comments echo the advice of many successful investors. For instance, it’s been noticeable in all my recent interviews with highly successful UK investors, that they all take a similar line on selling losers. In simple terms: get out early and you’ll feel a lot better. Fund manager Mark Slater has a general principle of selling on bad news, Robbie Burns advocates strict stop-losses, while Lord Lee of Trafford also advises having a fixed plan on when a holding should be sold. I know that the subject of my next interview, Giles Hargreave, takes a similar approach.

In academic literature, the statistics on the trend for investors to hold losers speak for themselves. When I’ve written about the disposition effect in the past, I’ve mentioned work by Terrance Odean. His classic study of 10,000 accounts at an American broker between 1987 and 1993 found clear evidence of investors selling winning positions over losing positions. And they paid the price - on average the losing stock that was held…

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As per our Terms of Use, Stockopedia is a financial news & data site, discussion forum and content aggregator. Our site should be used for educational & informational purposes only. We do not provide investment advice, recommendations or views as to whether an investment or strategy is suited to the investment needs of a specific individual. You should make your own decisions and seek independent professional advice before doing so. Remember: Shares can go down as well as up. Past performance is not a guide to future performance & investors may not get back the amount invested. ?>

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26 Comments on this Article show/hide all

vik2001 10th May '16 7 of 26

NWF is also another example of a stock that was part of the NAPS and has kept falling. in this case fair play to stop loss being set at 20%

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ACounsell 10th May '16 8 of 26

vik2001, Yes had NWF (LON:NWF) too and that went the way of Cambria Automobiles (LON:CAMB) though at least hasn't bounced back as yet...

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vik2001 10th May '16 9 of 26

NWF probably wont bounce back till the milk dairy prices go up. Its whats bringing it down. The time to buy back in is when milk goes back up

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GrindertraderUK 10th May '16 10 of 26

Thanks Ben!! I'm keeping quiet LOL

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TangoDoc 11th May '16 11 of 26

The trouble with any inflexible stop loss system is surely that the entire market is fluid and prone to being messed with at any moment by global events, loose mouthing from bankers and politicians and the actions of speculators manipulating the market. I often see sudden falls in value of certain companies in my portfolio and search in vain for any logical reason. I tend, therefore, to use the criterion of yield as my trigger to sell. Because my over-riding strategy is buy and hold for dividends for reinvestment within an ISA, as long as the reason for the drop is not a significant profit warning that reduces the dividend yield below 3.6 percent of the money originally invested, my criteria are often still satisfied. i compare this situation to the one where the value of the house I live in fluctuates. While I enjoy living in the property, why would I sell it because someone else values it less?

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Blissgull 11th May '16 12 of 26

But the primary purpose of your house is as a home not an investment. If you own a portfolio of houses as investments it may well make sense to sell if prices are falling.

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TangoDoc 11th May '16 13 of 26

In reply to post #130985

The primary purpose of my portfolio is dividend yield. I'd only move house if the benefits of living in it reduced beyond a certain level. Perhaps a more accurate scenario would be a second home I let out?

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PhilH 11th May '16 14 of 26

In reply to post #130993

So to be clear you are saying that you wou;d invest £1m with me and you will be happy for me to only give you back £500k if I guarantee a 4% yield?

Professional Services: Sunflower Counselling
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vik2001 11th May '16 15 of 26

for me a div isn't to important, I focus on growth within the share price. div can always be cut if the company isn't producing the required results, but yes its nice to have a div while im waiting for the share to trend upwards.

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TangoDoc 11th May '16 16 of 26

In reply to post #130995

Given that Inheritance tax will take 40% once I'm dead ( which will provoke the inevitable sell-off), we're not far away. Guarantee? I like that a lot! Just think what I can do with your £40K annual blessing! You're far more generous than some equity release deals. Are you sure you want to do this?

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PhilH 11th May '16 17 of 26

In reply to post #131001

Since switching over to Stockopediamy annualised return rate over the last three years is  approx 20%.

Why would I want to give 16% away plus half of my capital?

There's a reason why investment bankers drive expensive cars.

Edit: to correct the approx symbol

Professional Services: Sunflower Counselling
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TangoDoc 11th May '16 18 of 26

The key word was "guaranteed" but you also forgot the tax implications too after I am so dead, I don't care who else benefits!
Incidentally, thinking of investment bankers driving expensive cars, I justify mine by the numbers of hours I spend researching and I presume so do they. As a matter of interest, has anyone costed the time they spend managing their portfolio and deducted it from their overall investment earnings? Or do we think of it as a hobby; the "golf that pays for itself."

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PhilH 11th May '16 19 of 26

In reply to post #131009

but that's just the thing. They don't even need to guarantee 4% to get people to part with their money.

We give them 16%+ and half of our capital and we're grateful. lol.

When we could earn it ourselves, pay 40% tax towards supporting society, whilst giving our 60% to the ones we love or causes that mean a great deal to us. In the meantime before our inevitable death, we enjoy the benefit of the 16%+ returns.

It's a no brainer for me but each to their own.

Professional Services: Sunflower Counselling
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LovelyLovelyGorgeous 12th May '16 20 of 26

I use a 10% trailing stop loss in a googledocs spreadsheet which is formula driven. All I have to do is increase the stop price if the SP is rising and if "SELL" flashes red I review the situation. Unless there is no good reason for the drop, I'll sell. It is not perfect but it gives me a kick in the pants to do something.

I find when to sell a far harder decision to make than when to buy.

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AnonymousUser252054 3rd Sep '16 21 of 26

When I was a regular small-time amateur investor/trader twenty years ago I determinedly held on to a falling share over several weeks, buying more all the way to the bottom until cashing out at 2p/share (peak had been around £1 I think it was). There was no internet back then so only insiders knew that the company's assets (golf-courses) had been ludicrously over-valued and repeatedly signed off by a useless (big-name, well-paid) auditor. So I always admired people who used a stop-loss, and after reading this article was inspired to give it a go... but now I'm not so sure.

Within the space of six or seven weeks I've learned that determining to sell once a share has shed a certain percentage has worked against me on four out of four occasions (each time after a ten per cent fall). Soon after bailing out I've watched prices turn around and tick back up a half or even a couple of per cent every day or so with hardly a pause. I would have made good gains on all of them, but on only one of those four occasions did I buy back in - luckily, as it turned out. It's hard buying back in at a higher price than I had sold at a week or two before. They way I look at it now was that the value had been there all along, my timing was slightly out and I lost my nerve.

I dont think the markets have been particularly volatile since the beginning of August, but if I use a stop-loss again it will be set at 20%, if not 25%, and applied only if I can see a reason for a sliding share price.

I think other Stockopedia articles on over-trading and loss aversion are more helpful.

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Whitbyview 4th Sep '16 22 of 26

So having tried stop losses and having been badly burnt (selling £RDSB and Rio Tinto (LON:RIO) right at the bottom, since when they have made a very good recovery) on the referendum result I decided to top up a number of my shares. Stop losses would have had me sell a large part of my portfolio. As you may have seen in other posts about SCS (LON:SCS) and SafeCharge International (LON:SCH), the result has been remarkably pleasing. I'm not saying stop losses do not work (clearly in some cases they do) but it seems pretty pot luck when this is. I certainly will never leave an automatic stop loss with my broker again after one stock apparently dropped 10% for just long enough for my trade before recovering to its previous price. One piece of advice I read here I think (which I like) is to only use a stop loss on company news and not on general market movements. This is why I didn't sell on the referendum result and it has worked out well so far.

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Nick Ray 6th Sep '16 23 of 26

Theoretically, in a reasonably efficient market, applying a stop-loss to the stocks in your portfolio will give the same mean return as shorting the index the stocks are drawn from, but with higher volatility.

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ls2g08 6th Sep '16 24 of 26

In reply to post #149523

Nick could you expand on this or link to somewhere which describes this further, sounds interesting! Is this assuming mean reversion?

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Nick Ray 6th Sep '16 25 of 26

In reply to post #149526

It's a consequence of MPT (Modern Portfolio Theory) and it all hinges on what "efficient" means. Basically if you pick a portfolio as a subset of an index (or by some rule, such as SR>90) then the portfolio will have a mean return the same as the index but with higher volatility. If you then apply a stop-loss rule the rule will sell stocks "at random" from your portfolio. The subset of stocks it sells will also have the same property (mean return same as index) but since you are selling it is equivalent to shorting the index.

If you argue that the stop-loss rule is not selling "at random" but in reaction to a price move which is indicative of the stock's future performance then in mathematical terms you are arguing that the market is not "efficient". But then we would have to debate whether stop-losses are in fact able to exploit an inefficient market. However before you get that far, check whether your stopped-out stocks as a group track the underlying index after being sold. If they do, you are selling at random.

A good easy-to-follow explanation of MPT is here:

(The Wikipedia explanation is way too technical to be useful as an introductory text.)

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Terry the Trader 11th Jul 0 of 26

The 3 golden rules of investing

1. Cut your losses


3. Run your profits

I have a very strict stop loss system.

I make running stop loss between 10% and 20%

When I buy a share  I look it up on sharescope to bring the 1 year chart up. I then run an 10% stop loss line under the share price. If it does not fit I try up to 20% and to get the best fit.

In my spreadsheet make a column that check if the share price moves up, if it does then I move the stop up too.

This works for me, and that's all the agony out of shall I sell or not.

  It a bit more complicated than that, but that the basics. 

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Ben Hobson

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