Being a successful investor is just as much about limiting losses as it is about riding a winning stock. Downturns are a part of life in the market, and you must act decisively to shield yourself from excessive losses. If your stock selection does not work out and you are faced with a loss, don’t let your pride stop you from admitting that you have made a mistake and acting quickly. Cut your losses early and move on. You must make rational decisions, instead of trying to rationalise your way out of a costly mistake.
It doesn’t help to get emotionally tied to a stock or to the buying price. Some investors take too long before finally acknowledging that they were wrong all along. By the time they exit, their losses have already become too large.
The bigger the fall, the harder it is to recover. Say you bought a stock at Rs 100 and it falls 20% to Rs 80. To get back to Rs 100, the stock now has to make a 25% gain (see chart Uphill Task). The impact gets compounded if the fall is steeper—a 50% fall will call for a 100% gain from the bottom to come back to the old level.
When the markets are booming, this climb might be possible, but in turbulent times, it might be a better idea to cut your losses early. You might be tempted to hold on, as some analysts might believe that the stock you hold is due to rebound. Just remember that analysts are human too and have been known to make mistakes. Selling early could help you arrest a bad loss.
When booking losses means making profits
|• Look at the net profit or loss of your entire stock portfolio|
• That will give you a clearer understanding of the winners and losers in your portfolio
• Depending on the share of stocks in your total investment and the time till you want to stay invested, take a call on which stock to sell and when
• In this example we have taken a maximum of 8% loss as trigger to sell
• The extent of stop-loss trigger should depend on your risk appetite
• In the table above the investor could have waited longer to see if losing stocks had turned profitable
• But that would have also meant exposing himself to bigger losses in future
• That would have turned the net value of his total stock portfolio negative
• The diversity of stock in the portfolio helped the investor retain a positive net value at the time of exit
A good way of minimising losses during turbulent times is to place a stop-loss. You tell your broker to sell (or buy if you have short-sold a security) a stock once it reaches a certain price. For instance, setting a stop-loss order for 5% below the price at which you bought the stock will limit your loss to 5%. This is especially useful in case of shares that are very volatile. Assume you own 100 shares of JSW Steel. On 24 March, the stock lost over 12% (that’s Rs 107.75 per share of Rs 896). If you didn’t place a stoploss order and sold at the end of the day, you would have lost Rs 10,775.
However, if you had set a 2% stoploss trigger, your loss would have been just Rs 1,792. Even a 3% stoploss trigger would have arrested your loss at Rs 2,688. Setting a stop-loss gives you option to gamble a little. That’s because you do not offload your shares right away—you only tell your broker to sell them if the price falls to below your comfort level. In bearish markets you end up losing less than you might have if the share you bought crashed.
However, keep in mind that stoploss orders can also result in opportunity losses. A stop-loss triggers should not be very close to the market price of the share. If the market is just a bit volatile this share might go down to the trigger price, activate your stop loss and then bounce back to a higher price. You lose out because the intra-day volatility triggered off the sale of your shares.
Any type of investing is somewhat of a gamble. There is no guarantee that your investment will be protected against loss. But the key to making money in risky investments such as stocks is to diversify your portfolio. That way, you are almost certain to have some investments that will do well when others are not doing as well. In addition, you should also expect to diversify your portfolio among different types of stocks.
For example, your stock portfolio should generally be a mix of blue chips, large caps, growth stocks and dividend stocks. Most of us do not look at our portfolios in their entirity. We tend to look at the performance of individual stocks. However, what we ought to be doing is looking at the average returns as the metric of growth rate, or the annualised returns that the portfolio has earned, rather than considering the performance of individual stocks. In an ideal situation, all stocks in a portfolio should be moving up but in reality it seldom works that way.
Consider the hypothetical portfolio given in the table. Notice that while it has blue-chip stocks, their prices and performance fluctuate over time. As you can see, even if you had made these trades over a period of time—and taken losses on five of the eight stocks—you would still come out ahead by Rs 1,500.