Taking a big loss can wreck your portfolio.
That’s the biggest reason a typical individual investor underperforms the market.
According to a 20-year study of the market by asset manager J.P. Morgan, the S&P 500 index returned 6.1% per year from 1999 to 2019. Individual investors averaged just 2.5%.
The single biggest reason for that is taking a big loss.
Let me show you…
Say we had 10 stocks in our portfolio. And we invested $1,000 in each stock. If we bought Stock X for $10 and sold it for $1, we lost $900 on that trade.
We have $100 left from that original $1,000. That means we need our next investment to go up 10 times, to recover from that loss.
From a portfolio standpoint, that loss represents 9% of our entire portfolio…not great. We need all the other positions to go up 10% on average, to recover that loss. That’s a lot harder than it looks on paper. And that will only get us back to zero, with no gain for the year.
That’s why big losses can be devastating to a portfolio.
At Mangrove Investor, our philosophy is to minimize our losses to 25% to 30%. Here’s why…
If we took a 30% loss on Stock X, it would have been $300. Then we only need the remaining $700 (from our original $1,000 investment) to go up by 43% to recover the loss. A much easier goal than 1,000%.
More importantly, that only represents a 3% loss to our portfolio. So, if we could average 10% returns across the portfolio, we would still show a 7% gain for the year.
That’s why we use trailing stops.
A trailing stop tells us exactly when to sell our position, based on math, rather than emotion. It limits the amount of capital we risk on any given position. We never, ever want to risk all our capital. Typically, we risk 25% to 30% on any given position. That’s $250 to $300 on a $1,000 investment.
The trailing stop tracks that value, based on the highest closing price of the stock. For example, let’s say we bought $1,000’s worth of a solar power company. We bought 10 shares at $100 each and used a 25% trailing stop.
Our trailing stop would start at 25% of $100.
If the stock price closed below $75 per share, it would trigger our stop – telling us to sell our position.
That can be hard to do because we don’t want to take the loss. That’s why we use math and not emotion to tell us when to sell.
Emotionally, we are never prepared to sell a stock at the right time. When they are going down, we hope that they will come back up. It’s human nature…and it will hurt your investments long-term.
Trailing stops are great for setting exit prices after big gains too. I personally know too many people that did everything right on a stock…except sell.
Take base-metal mining company Teck Resources (NYSE: TECK) for example:
The metal market soared in 2009, as the market recovered from the 2008 crash. Investors watched their positions rip higher. It was fun.
Teck shares ran from under $2.50 per share in March 2009 to over $55.00 per share by March 2011. In just 2 years, investors could have made 2,100%. That kind of gain turns every $1,000 into $21,000.
However, in 2010, demand for these metals faded. The market softened and the big fund managers began to take money off the table. The selling drove shares lower.
Many individual investors did not do the same. They loved Teck. The rush of the stock soaring was fresh in their minds. Rather than staying objective about their positions, they let emotion control their actions.
Unfortunately, hope is not a financial strategy.
By June 2012, Teck shares fell to $25 each. The cut the potential gain down to 900%. Still great but falling fast.
However, shareholders that bought and held Teck shares saw the share price return to $2.50 by January 2016. All the gains evaporated.
But that was avoidable. There is a way to salvage these situations, using math, rather than emotion.
A 25% trailing stop would have triggered a sell at $41.25 per share (based on the high price of $55 per share). That would lock in a 1,550% gain on the position.
That’s the important thing about trailing stops. They protect our capital on the downside and protect our gains on the upside.
If you want to become a better investor, trailing stops are the best way to do it.
For the Good,
Matt Badiali
