3 Loss-Hedging Techniques for Stock Investing Success
By SmartProInvesting.com Stock Investing Team.
February 21, 2008
Many potential investors are scared stiff of losses and sometimes choose to keep off the stock market. They hear of the yo-yo of stock prices and can’t think of risking such price swings that can’t easily be controlled. Unfortunately, when that happens, the opportunity to profit from market is also lost. Certainly, there is good reason to worry about losses, because nobody is keen to throw money away. The truth, however, is that in today’s market, your chance of profiting is, on balance, much higher than the probability of loss-making. It would be a bigger loss, in the circumstance, to ignore the enormous wealth-building opportunities of our stock market.
What is needed is, first, to accept the reality of the possibility of a loss. It is a possible cost for the potential for profit. The next thing is to seek the means to cover one’s flanks in the market and to minimize the risk of loss. Certainly, it would be foolhardy to walk into a minefield, blindfolded. With the right tools, it is still possible to navigate through, with reasonable safety.
Understanding Loss Dimensions
There are different dimensions of loss and it’s good to understand them. A full capital loss will occur when the price of your stocks falls below the level at which you bought. Here, you are short in an absolute sense. That could come right from when you bought the stock, meaning that it never enjoyed any gain.
Such capital loss could also arise after the stock has gained in price and subsequently come crashing to below your entry point. This kind of loss results, most times, from the investor’s desire to extract the maximum gain from the rising stock, which unfortunately reverses and tumbles at some point. Here, accrued profit is first lost, and in some cases, the capital investment.
The price fall may also fail to hit the level at which you bought in, meaning there is no capital loss. The loss of already accumulated gains, which it amounts to, is still as painful.
It’s also possible that your stock simply fails to fly, but does’t depreciate. In such case, you could argue that there is, at least, no loss. However, you need to realize that there is a risk-free return you can earn by investing in treasury instruments, for instance. If you don’t earn this minimum from your stock investment, there is an implied loss.
These forms of loss all negate your successful performance in the market. While it is quite difficult to totally avoid them, every investor should strive the limit their damage. So, here are three strategies you can apply to great benefit:
- Build Strength into Your Portfolio
Investors are obsessive about high returns and are looking for the maximum possible. Yet, a balanced view of the investment process is not only reasonable but may in fact be the realistic approach. The market is susceptible to chocks that can arise unexpectedly. When subjected to such stress, prices are the victim and the scope of fall for individual stocks will depend on the strength of each company. Some potentially high returns stocks which may also pose higher risk will possibly be the worst hit. Often, such companies are growth or low-cap companies which are yet to build a track record of resilience. The highly capitalized, stable and generally resilient companies may post a lower rate of return, especially because of their higher stock prices. Yet, they provide some defense to your holding. One way to safeguard your investment is therefore to deliberately decide the shape of your portfolio, designed to achieve diversification both laterally and vertically. What this means is that even while considering expected returns from stocks when selecting, you should also seek to minimize risk through diversification: across a few sectors of the market and also across a few classes of stocks. If you expect high returns from insurance companies and you invest in only insurance sector stocks, what you have is a high-risk holding. If you reason that ‘penny’ stocks are earning more and you buy only stocks in that fringe category, it’s also a high-risk portfolio. Avoiding to expose your investment to extreme risk of loss from over-concentration is helpful to your investment process.
- Use a Stop Loss Order
A clinical approach to dealing with losses is to use a stop loss order. Usually, this is a standing order you place with your stockbroker. If you can’t arrange that with your broker, it means you have to set the trigger to yourself and if activated, you can then place a sell order.
But what is a stop loss order? It is an order placed with your stockbroker to sell a specific stock once the price hits a particular level. A stop loss order is typically set at a percentage below cost or a specified figure. Take this example. You buy 1,000 units of Dangote Flour Mills at N20.00 per unit and decide you can’t risk more than a 15% loss on the investment. So, you set a stop loss limit of 15% (or you may also say N3.00) on the stock. What this says to the broker (or yourself) is that if the price ever falls to N17.00, it should trigger a sale. In effect, the stop loss order becomes a market order (or still, a stop limit order) to sell. Recognise that the stock may not be sold at exactly N17.00, as much will depend on demand, but the process to sell is triggered at that level. If sold at somewhere less, your actual loss will be more than 15%, except that it possibly would be much worse without an automated trigger.
The benefit here is that the risk of oversight is eliminated. Your stock can substantially lose value before you realize it, without an automated trigger, a kind of circuit-breaker. Also, the sentiment that could dog your decision process and bring confusion or indecision is eliminated. Stock is put up for sale if the set condition is met.
Like with everything, there is a downside. The price fall could be short-lived and stock easily bounces back. You still enjoyed protection but possibly wouldn't have sold, if you were sure it wouldn’t continue. However, when protecting your capital is important to you as a first priority, it is a price worth paying. One way to reduce that possibility is by setting at a reasonable margin of price fall where you can’t risk much further fall.
- Deploy the Trailing Stop Technique
This is a more protective strategy that not just aims to limit to a specific amount of capital loss but works to safeguard increasing amounts of earned profits. A trailing stop is built on a stop loss order, but is set to maintain the stop loss order at a percentage (or spread in Naira) from current market price. In effect, in a rising price situation, the trailing stop will continue to rise too. Let’s look at an example. You bought into National Sports Lottery at N8.00 and the price has been steadily driving up. You don’t want to cut your gains short, so you are ready to ride it out. As a protection, however, you leave a trailing stop of 20% on the stock that tells your broker to sell if the price reverses by a single stretch of 20%. At market price of N15.00, that’s a N3 spread or stop order price of N12.00. At N20.00 market price, the sale order is triggered at N16.00. If the price still moves to N30.00, a sale order will be triggered if it reverses to N24.00.
The rate you will apply will depend on how much loss you can tolerate, knowing again that some short-term reversals will correct soon after. Benefits are similar to those of the stop loss order. You automate the process, freeing it from emotions (should I sell, should I not?), protect your investment and still keep driving for more earnings.
Renowned stock investing strategist and author of the investment classic The intelligent Investor, Benjamin Graham, is noted for stressing that protection of one’s capital should be the first objective. Learn to put strategies in place to secure your investment, even if that means not maximizing earnings. If you exclusively focus on high returns, you could take on undue exposure that might excessively put your capital at risk. Automated triggers also provide a clinical solution to the decision process, removing prevarication.
|
|
