By Nick Louth, MSN Money special correspondent
If there is one simple thing every investor should know, and will unfailingly boost returns, it is how to cut losses।
If there is one simple thing every investor should know, and will unfailingly boost returns, it is how to cut losses।
Cutting losses quickly is probably the single most important tactic in getting market-beating investment returns। It is also without doubt the hardest technique to follow relentlessly because it usually means admitting to yourself that an original purchase was a mistake.
Trends last longer than we think
Many investors held on for years, thinking; “They just can’t fall any further.” Oh, yes they could.
Instead, by having an iron rule which says sell when any stock falls, say, 20 per cent, it is possible to save thousands.
The theoretical effect on your portfolio is pretty simple। In effect, by running with profits and cutting losses you are keeping as much of your capital as possible in investments that are increasing in value.
How to set stop loss limits
The first stage in cutting losses is to formulate a policy, which you should write in bold across your investment diary, and have on a note stuck near your computer screen.
When deciding your limit, you certainly need to make room for day-to-day fluctuations in share prices, so that sales are not triggered too easily, but you must not set the limit so low that you have already lost a fortune by the time it is triggered. It will also mean some fairly regular checking, so that you are aware when your investments are adrift.
Here are a few types of stop-loss:
- An absolute fall: e.g. sell on any fall of 15/20 per cent in a week/month. This has the advantage of simplicity, but may have you selling more often towards the bottom of a bear market, even when value is apparent, than towards the top of a bull market, when it isn’t.
- A relative limit: e.g. Sell if the stock underperforms the FTSE 100 by 10 per cent in any month. Though more complex, it gives you the right background against which to judge a price movement.
- • Sell at a specified price: If your broker allows you to set limit prices, you can set conditional trades, which are always expressed in absolute pence. As these instructions can be set for months ahead, you must update them regularly to reflect the right stop-loss gap underneath the current price. To do this for every stock in your portfolio would be very time consuming, but there are likely to be those which you are most concerned about. If you are going away on holiday, however, it can give great peace of mind.
What about those that recover?
Let’s not make any bones about it, if you sell loss-makers early you will not yet know for sure whether this is the start of a short period of downbeat trading in that particular stock, or the start of a calamitous decline. However, while you may miss out on those stocks which manage to reverse a 20 per cent fall, you will never be caught napping by those miserable firms which are on their way to bankruptcy and intent on destroying your wealth on the way.
Removing emotion from the decision
Ultimately, the success of cutting losses rests on your ability to remove emotion from your investment decisions. That is done easily if you act quickly, but once you wait until you have lost say half of a £10,000 investment in a company, it is harder by far to convince yourself to turn a paper loss into a real one. If it was a few hundred, then you can shrug your shoulders and move on. (If not, you probably should not be trying to invest in individual shares).
However, it is when you are already thousands down that the real devil may occur to you। This is the temptation to buy more shares in a losing company. This appears to have the advantage of lowering your average purchase price and therefore your breakeven level, but should be resisted at all costs.
Source: MSN Money
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