A practical guide to keeping losses small
I remember the first stock that I recommended for purchase across all our client accounts in my private client group at Goldman Sachs. I was 22 years old and had to comply with the "process". That process meant that shares needed to have been recommended by one of our research analysts, who sat on a different floor to our investment team. I had been watching an Ed-Tech firm with the ticker symbol, CBTSY, and for no apparent reason, it had fallen about 30%. I applied the process, phoned the analyst who confirmed he had just spoken to the CFO very recently and that there was no change to the story. We bought it across all our client accounts.
The next day, the shares slumped dramatically on a profit warning. My boss, with more experience than I, immediately sold, and we took a £1 million loss across the accounts. There were many lessons that I took from this. I rarely trusted research analysts again, but more importantly, learnt the lesson of taking losses quickly. CBTSY continued to fall over the coming months.
As much of the stock market grinds lower, more and more shares are reaching bargain valuations. But markets can stay irrational longer than you can stay solvent. If you buy stocks, you are going to pick some losers, no matter how cheap they seem. This creates a quandary. What should you do with your losers?
In this article, I will illustrate the importance of keeping losses small with a few mental models and some practical guidance on loss management.
Fighting the inclination to hang onto losers
Daniel Kahneman and Amos Tversky extensively studied human behaviour towards differently framed opportunities in their famed “Prospect Theory”. What they found is that we have a tendency to be risk-seeking in our approach to holding losers, but risk-averse when it comes to holding winners. They found that we feel pain of losses more than twice as much as the joy of gains.
The chart below is a handy illustration of this effect.
Psychologically, we don’t believe we’ve taken a loss until we’ve sold a share, so we avoid selling as we think “it might come back”, but we tend to sell gains too quickly, as we say to ourselves “we might lose our profit”. So we snatch at gains, and hold losers. This is the completely opposite behaviour to the age-old winning investment maxim to Run Winners and Cut Losers.
If you don’t fight the tendency to hold on to losers, and fight the tendency to sell winners, making any money in the stock market is an uphill battle. Just remember, our psychology is not well adapted to this behaviour, so we have to force ourselves to learn this habit through practice.
The larger the loss, the ever larger the recovery
The value of keeping losses small is no better illustrated than in the graphic below. If you lose money, the gain required just to recover the loss grows by a power-law. If you lose 50% on a position, that position will need to double just to return you to breakeven. If you lose 90%, it needs to gain 900%.
This is such an important mental model. Burning the below graphic into our minds helps considerably when thinking about what to do with losers.
Instead of thinking about cutting losses as an admission of a mistake, or as an unnecessary commission to your stockbroker, think about them as an insurance premium. There’s great comfort in paying car or home insurance, so why not consider small losses as a premium paid to preserve your capital?
More than this, if you think “keeping losses small” is just a trader’s maxim, think again. None other than the great Warren Buffett has hammered home two rules of investment. Rule #1: don’t lose money. Rule #2: don’t forget the first rule.
Buffett is of course the greatest investor of all time and has an incredibly high hit rate for identifying long-term, compounding winners, but if he makes a mistake he gets out. It’s not exactly easy when you invest at the scale he does, but his Tesco investment is a good example. Bought in 2006, the business deteriorated through 2013. He was mostly out in 2014. While Tesco hasn’t slumped more since, the opportunity cost of having his capital in an underperforming stock was significant. He had better uses of the funds. Don’t hold losers.
Of course, Warren Buffett’s approach to avoiding losses is to ensure that all purchases are made with a significant Margin of Safety between the price paid and the true intrinsic value of the investment. This lesson was taught by his tutor Benjamin Graham, the “Father of Value Investing” as the most important principle of investment. If you buy with a high Margin of Safety the likelihood of significant losses is reduced. He also espoused broad diversification across undervalued stocks to ensure the risk of losses on a single investment could not impair capital to a significant degree.
Whatever your style of investing, not losing money is the most important principle for ensuring strong gains. If you keep your losses small, the gains take care of themselves.
What to do with losses
The book “The Art of Execution” by Lee Freeman-Shor has a useful model for what to do with losers. He studied the results of many fund managers over a multi year period. He identified the habits of fund managers handling losing positions and classified them as assassins, hunters and rabbits.
- Assassins - those that act quickly and cut their losses on losing positions.
- Hunters - those that bought more, averaging down when prices fell.
- Rabbits - those that did nothing on losers. Stuck in the headlights.
He found that out-performing fund managers were decisive - either Assassins or Hunters - whereas Rabbits were consistent under-performers. So you only really have two options when you are present with a loss. Cut losses or average down. Doing nothing is not an option.
As an amateur investor, your ability to identify the right stocks to average down on may be more limited. If a share really does have a strong Margin of Safety, then purchasing more can make sense, but it's easy to become extremely overconfident on even a limited amount of research. You may well be wrong. Not only this, but if a share price falls, it has negative momentum and many investors will have regretted their purchase at higher prices. These present headwinds to share price recovery. This is why I personally believe taking an assassin approach is quite a sensible approach for many investors.
Using stop losses to keep losses small
Much of the professional investment community rejects stop losses, mostly because they are hard to use when deploying large scale funds, but individual investors, deploying smaller capital, have no such constraint.
The mistake that most investors make with stop losses is to use the same stop loss level for all positions. They pick something arbitrary like 10% and wonder why they get whipsawed out of their small cap positions regularly. There’s nothing worse than selling your position on a 10% loss only to see the stock bounce back above your purchase price the next day.
The key is to set stop loss levels in relation to a share’s price volatility. More volatile shares are more likely to hit tight stop loss levels. So use wider stop levels for more volatile shares.
A reasonable shortcut is to use Stockopedia’s RiskRating Classifications or the “6 month Volatility” metric which is available to add to tables. I find that using the 6 month share price volatility (or less) to be a reasonably effective stop loss level for many shares.
In terms of coupling stop loss levels to the RiskRatings, I’ve found the following rules of thumb quite useful. We applied these in our Staff Investment Club to good effect, one example being LoopUp which we were stopped out of at 192p for a 22% loss. LoopUp’s shares now trade at 2p.
The RiskRatings are published at the top of all StockReports in the Classifications section.
If you can’t stomach stop losses…
And just to finish off this piece, if you don't use stop losses then there is one final rule. It was first promoted by Peter Lynch in his essential "One Up On Wall Street" and reiterated by Jim Slater in his excellent "Zulu Principle" pair of books.
Sell when the story has materially changed.
As a stock picker, whenever you buy a share, it's imperative to have a strong grasp of the "story". Peter Lynch will try to write a two-minute monologue about a share’s narrative, which he would use to clarify his thinking, and refer back to through time. Keeping a journal, or record, of the reasons why you bought a share can help you reassess the continued investment case when things change.
Things do change. Profit warnings. Management mistakes. Di-worseifications. Competition. Limits to growth. External disasters.
The great lesson I learned very early on with CBTSY, was that you should cut your losses as soon as the story has changed. Even if it’s the very next day.
I am sure that many in the community have their own rules for keeping losses small. Ultimately, the best is to buy with a good margin of safety and time the buy well - arts in themselves.
Please let me know your own thoughts and principles, and I'll try and reply when I can.
About Edward Croft
Co-founder and CEO here at Stockopedia.com. I was a wealth manager, then full-time private investor before setting up Stockopedia. I believe passionately in the power of data-driven investing to improve investment results. Oddly obsessed with the StockRanks.
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Good question! Thinking, Fast and Slow is essential reading, IMHO, for anyone involved in making financial decisions.
I think it is important not to confuse 'Fast thinking' (i.e. heuristics) with fast reactions.
The time for slow thinking is before purchasing any financial instrument. How much do I hope to make? How much am I prepared to lose? Is the purchase price right? etc.
Once the purchase has been executed, then it makes sense to stick to the pre-purchase plan. Even if you have sell a few hours later.
If one reviews the carefully laid plan in order to justify increasing the loss, that is fundamentally 'Fast thinking' (i.e. loss aversion) rather than rational slow thinking. Even if one spends a long time thinking about it.
Paradoxically, thinking slowly is not the same as Thinking, Slow. It is an inefficient form of Thinking, Fast.
At least that's my view. (And I've hit rather a lot of stop losses recently. Painful, yes. But no regrets.)
Hi Ed
I got attracted to your site and have stuck with it because of your objective quantitative approach, in particular through the NAPS method. This article appears to drift towards 'story share' territory. There are other sites that go in more for the 'story' approach (e.g. Motley Fool). I think your NAPS performance beats them? I thought I read on one of your NAPS articles that it's best to stop fiddling and resist over-complicating (e.g. with stop losses) - just stick to the simple rules and leave it at that. Am I recalling correctly?
Quite rightly the article focusses on selling bad investments because this causes the damage of drawdown.
A second article could be on selling winners. Buffett may say that he holds forever, but this is obviously absurd if the price is way above value and you can buy back two years later at half the price.
Perhaps sell when the value or quality rank falls below 80 is a good rule.
Yep I agree with this. I don't use stop losses and never will.
I'm an investor - I'm not a trader!
I try to buy good quality businesses at reasonable valuations and strongly believe that time in the market will usually beat timing the market.
The problem with stop losses, is when do you get back in? You could literally end up losing 50% of your portfolio and have zero holdings - it is actually very dangerous imo in this type of market - it ends up being 'death by a thousand cuts'. You could literally lose a fortune on the same stock just because we are in a volatile market and your entry price wasn't timed to perfection, because your crystal ball broke that week and the market sentiment drove the SP lower (nothing to do with the quality or the value of the company). A volatile stock bouncing about could stop you out several times - without a very precise re-entry strategy - this makes the strategy very floored imo.
During tough bear markets - I always ask myself this question - Would I rather keep my portfolio or would I rather have my looses back (obviously with the caveat that I cannot invest again!) My answer is always that I would rather keep my portfolio of companies. I might need to make some amendments to ensure I have the correct balance and quality of holdings - but the actual ticker price movement is irrelevant during times like this when prices are mainly driven by sentiment rather than the individual businesses fundamentals. I sleep at night knowing that I own some great businesses that have very bright long term futures. If I kept taking losses on business that I liked, and kept seeing my portfolio going down in value without anything tangible to hang on to - I personally would find this intolerable. The reason I can stomach the losses is because I believe in the long term success my portfolio of companies - and therefore I do not need to sweat every daily move.
For those that would rather take their (refund) losses back - I think you need to improve the quality of your portfolio or perhaps invest with a fund manager. Because this is the key to being an investor. Invest in good companies and be patient - Buffett keeps telling us how simple it is - it really is not rocket science. So if you are not comfortable with the volatility of a bear market - then perhaps the personal management of your money should be left to an expert fund manager / asset manager.
Hi Ed,
The stop loss % you have shown how applicable are they when you have an overall slide on the markets such as the problems in Isreal at the moment and the concern a lot of investors have about higher interest rates. I have quite a lot of stocks which due to market conditions are minus 20% or more. It is quite difficult to sort out what is down to market conditions and what is down to the stock itself, a lot of my minus stocks have very good fundamentals.
regards
Melvyn Frewin
@London2000 - there are different approaches to the top of the mountain. Whats important is to find an approach that suits your psychology.
The late Van Tharp once said that "you don't trade the market. You trade your beliefs about the market. ". I think this is brilliant wisdom.
What you find in discussions such as these is that people end up counter pointing different belief systems. It is possible for everyone to be right, even when they have diametrically opposed views.
So the "hold forever" crew are right in the sense that their belief system is based on a long-term holding period, owner-earnings analysis, and that quality compounds capital. The cost of this belief system is deep investment in fundamental analysis, over attachment. plus fully invested drawdowns.
The "stop loss" crew are right in the sense that capital preservation is key, the market is right, there is an opportune time to buy, and not to fight the tide when it's going out. Thats another belief system. The cost of this belief system is more activity, higher costs, being prepared to hold cash in bear markets and being bold enough to re-enter when the time is right.
The "systematic equity" mindset (a la NAPS) is also right in the sense that there are equity return drivers, that rebalancing keeps you exposed to them and that a hands off approach reduces the need for emotional control. The cost of this is periods of underperformance, a proportion of errors, and system fiddling.
Personally, I gain greatly from knowledge of all approaches, and use them where I see fit. I buy discretionary based selections, run systematic equity selections and use stop-losses where capital preservation is key.
All in all, what matters is knowing that you trade your beliefs, ensuring that your beliefs are sound (and ideally empirically backed), and ensuring emotional control.
At the end of the day, I believe statistics beat stories... but stories drive most of the fluctuations in equity prices from year to year.
Tony, I feel your pain and have been there. My feeling is that, as the article says, it is better to accept where you are, not avoid selling to "avoid the loss" since it is already real (yes, it really is) and use that capital that is then freed up to buy a better quality, value momentum share, perhaps by using the StockRanks to guide you and not (for me at least) the story.
Hi Ed
Thank you for your reply.
I have re-read it a few times and still can't quite see any contradiction in what I have written.
I have not used stop losses and if the fall is caused by a change of story rather than a Mr Market Hissy-Fit, then ones active following of the company should cause you to exit the company.
But if a company declines because of a buyers strike (few buyers than sellers at any particular price), then I am still not convinced that selling out is necessarily the correct course of action, and while buying more at the lower price might strictly be the correct course of action, it assumes that one has fresh cash to deploy, because if you don't then by definition it will necessiate selling another company.
I also think that this could lead (in a market that we are currently experiencing) to over activity and while it has not been comfortable I have almost done nothing this year (apart from selling Ergomed (LON:ERGO) ) because there just seems to me to be a lack of visibility (Ukraine, inflation, interest rates, Israel, Taiwan) and at the moment I am not prepared to go to cash.
Regards
Michael
This is a very useful article and I'm already taking the lessons from it onboard.
Basic question. You can buy a stock with a wide buy-sell spread, with a transaction cost, stamp duty and possibly forex charges. As soon as you've bought the stock you can automatically be down 3-5% sometimes. Do people set their stop loss from the putative sell price at the moment they bought the stock or from the price they paid?
When I started, for example, I sometimes tried to apply a tight stop loss of 7-8% as per Bill O'Neill's book but if I was instantly 3% down on the purchase then effectively it was a 4-5% stop loss. Which proved ridiculous. Hence I don't own ScS any more, but let's gloss over that....
@DWit199 - just circling back to your query. The volatility dropoff is because all our volatility measures are based on a daily volatility calculation over a 3 year lookback period. The pandemic was obviously an extreme event and it increased the volatility for stocks across the market. That event purged itself out this March, so volatility measures for all stocks fell.
There are always arguments over the "right" lookback period on stocks for calculating volatility. Some say 1 year, some say 5, but anywhere in that range is fairly normal.
There is an argument to say that the pandemic crash was anomalous, and therefore could be excluded. But black swan events do happen!
Here's a longer-term picture of the median LSE share volatility over the last 7 years (calculated each October). Given the market excitement through 2020-2021 I wouldn't be surprised to see the median annualised volatility drop further towards the lower 40% region.
Thanks Ed, that makes sense and explains what I have been seeing.
I have been doing some work on a trading system in python that uses forecast volatility (next 30 days) as a measure of risk and to size posistions. From a price history I use a long and a short exponentially weighted moving average, averaged with a 30:70 weighting long ewma:short ewma. This takes account of "grey swans" in the short term but forgets these one off and short duration events quite quickly in the long term. Unfortunately, I don't have the resources to calculate voatility in this way for the whole market.
It's always from the price you paid. The spread is an additional risk you need to factor in, but I would recommend you stick to the more liquid names, ideally with a average long term spread of 0.5% or less. In the UK, this will broadly limit you to the FTSE 350, a handful of mid cap stocks on AIM and small caps which were former mid cap stocks (e.g. Boohoo (LON:BOO) , Iqe (LON:IQE) , Saga (LON:SAGA) )
This of course pushes you away from where most of the alpha performance in the UK market comes from.. the small caps!
Very useful article and very much needed as the 'when to sell' is often not answered well. It is great to have Eds view on suggested stop losses linked to volatility since they act as guidelines for us with less experience. I think one question I have is in relation to the story changing point about 'external disasters' - does this mean a war or pandemic or ? I am still unsure what to do in these circumstances since often there is a massive fall and then a big bounce shortly afterward
I follow Slater and Lynch in writing down the reasons I have bought a share and, provided those reasons are still valid, I hold pretty much regardless. With most stocks, I am buying a trend, so I set a price when I buy, of where the price would have to fall to to break that trend, and that is my stop loss.
So if you've used stop losses (and I'm not knocking anyone who has) you're now sitting on 50%+ cash and the market has just bounced a few percent, what do you do now? Is it a dead cat bounce, or the start of a new bull?
I know I'd be highly uncertain about what to do in these conditions so just riding the volatility works for me. I have sold some stocks that disappointed operationally but not those who have just fallen with the general malaise. That has left me sitting on some large drawdowns & paper losses for sure but almost still fully invested, and no big decisions to make.
So, genuine question, when do you get back in?
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I would go by the StockRanks: Hold Liontrust Asset Management (LON:LIO) & Eurocell (LON:ECEL), and Sell dotDigital (LON:DOTD) & Central Asia Metals (LON:CAML)