Why it pays to cut a loss

Even long-term investors should have a clear philosophy for deciding when to cut an investment. Cris Sholto Heaton explains why.

784-strategy

Many investors never use stop losses. They tend to view them solely as a tool for short-term traders who often use leverage (borrowed money) and can be wiped out by a few big, ill-timed losses. If you're investing for years ahead, your portfolio is diversified and you don't use leverage, the threat from the odd big loss doesn't seem vast.

However, even long-term investors should have a clear philosophy for deciding when to cut an investment. If you buy a stock that drops 50%, it's possible that the market is overreacting but it's more likely that you made a bad decision. In that situation, you could hang on and hope for a turnaround, you could sell, or you could buy more. So which is the smartest bet? A recent book by fund manager Lee Freeman-Shor of Old Mutual provides some interesting insight.

Subscribe to MoneyWeek

Become a smarter, better informed investor with MoneyWeek.

Freeman-Shor studied how the different managers that his multi-manager "Best Ideas" fund invested in coped with losing trades. He found that investors who simply hung on performed worst, because the turnaround rarely came. Out of 1,866 investments in total, 946 lost money and 131 of those lost more than 40% before they were sold. Some of those 131 stocks recovered strongly after the manager sold, but just 21 doubled and none made it back to break even (if a stock has fallen 50%, it needs to double to get back to break even see the chart above). So if you take a big loss, the odds are against you.

Managers who sold when their stocks fell by a fixed amount did much better. The key was to sell at a level that avoided severe losses without being caught out by short-term volatility. Set the stop loss too high and the chances of bailing out of a share that would have made money was much greater: out of 421 trades sold for a loss of up to 10%, 249 would have gone on to be profitable. Given that average annual volatility for the UK market over the past ten years has been around 20%, somewhere between 20% and 30% probably makes sense any stock that falls by more than 30% in a year is being abnormally volatile.

Advertisement
Advertisement - Article continues below

Interestingly, the most successful managers were those who sometimes bought more when the shares fell, rather than always selling. However, this is risky (you can end up throwing money at a share as it enters long-term decline) and requires investors to be ruthless about ditching stocks when they no longer have conviction. Either way, it's clear that doing nothing is rarely the best move.

Advertisement

Recommended

Visit/investments/investment-strategy/600833/green-investment-from-sensible-re-pricing-to-full-on-mania
Investment strategy

Green investment: from "sensible re-pricing" to full-on mania

Change is afoot, says John Stepek. Everyone is waking up to the fact that we need to do more to protect the environment. That presents opportunities f…
13 Feb 2020
Visit/investments/investment-strategy/600804/the-secret-to-avoiding-being-panicked-out-of-your-portfolio
Investment strategy

The secret to avoiding being panicked out of your portfolio

With the coronavirus continuing to occupy headlines, investors still aren’t sure how to react. But the one thing you mustn’t do is panic. Tim Price ex…
11 Feb 2020
Visit/investments/investment-strategy/600772/just-five-assets-matter-for-investors-portfolio-asset-allocation
Investment strategy

Just five assets matter for investors. Here's what they are

Every investor’s needs are different – but most can be met by the right combination of five investments
11 Feb 2020
Visit/economy/uk-economy/brexit/600778/winners-and-losers-from-a-hard-brexit
Brexit

Winners and losers from a hard Brexit

Our exit from the EU is likely to be of the hard variety, says Matthew Lynn. Investors should back the industries that will flourish
9 Feb 2020

Most Popular

Visit/economy/uk-economy/600837/rishi-sunak-new-chancellor-spending-splurge
UK Economy

Britain has a new chancellor – get ready for a major spending splurge

The departure of Sajid Javid as chancellor and the appointment of Rishi Sunak marks a change in the style of our politics. John Stepek explains what's…
14 Feb 2020
Visit/economy/600814/money-minute-friday-14-february-the-latest-from-rbs-britains-state-owned-bank
Economy

Money Minute Friday 14 February: The latest from RBS, Britain's state-owned bank

Today's Money Minute previews results from RBS – Britain’s state-owned bank – and from pharma giant AstraZeneca.
14 Feb 2020
Visit/investments/property/600826/living-on-a-houseboat-the-pros-and-cons-of-a-floating-home
Property

Living on a houseboat: the pros and cons of a floating home

Living on a houseboat sounds romantic and peaceful. But it’s not as straightforward as it looks, says Nicole Garcia Merida
14 Feb 2020
Visit/investments/stockmarkets/european-stockmarkets/600725/is-2020-the-year-for-european-small-cap
Sponsored

Is 2020 the year for European small-cap stocks?

SPONSORED CONTENT - Ollie Beckett, manager of the TR European Growth Trust, on why he believes European small-cap stocks are performing well.
12 Feb 2019