How to cut your losses

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One of the most important routes to making money in the stockmarket is to make sure that the losses from unsuccessful investments don't overwhelm the profits you make from those that go well. Cutting losses quickly is the surest way to achieve this.

The problem is that emotion gets in the way.

It's a rare person who finds it easy to admit a mistake, particularly if that mistake has occurred despite solid research. A mistake that has cost money is harder still to admit. That's the main reason why many investors hold on to loss-makers for too long.

For more on the impact of emotions on your trading, read: Taming your emotions.

One way round this is to use stop-losses. Stop-losses are orders given to a broker to sell a share without further ado if the price drops below a certain pre-set level. Many brokers accept stop-loss orders, but even if they don't, you can operate a policy like this yourself by having a mental 'pain barrier' that prompts you to sell instantly the price hits a certain level, or if the position begins to lose more than a fixed amount.

The problem with broker-operated stop-losses is that they are not guaranteed. All the broker will do is look to sell immediately in the market once the stop-loss level is breached. But, if the market is particularly fast-moving, the execution price of your sale might be some way adrift from your stop-loss figure.

Guarantee

The exception to that is with spread betting and CFD operators. Because these are financial contracts with the financial bookmaker or CFD firm acting on its own behalf, they can guarantee to execute a stop-loss precisely at the price you stipulate.

Indeed, unless you particularly want to stay glued to a price screen all day, when you have a position open in a spread bet or CFD, it is always a good idea to have a stop-loss in place. These are highly geared investments, and you can lose your shirt in the time it takes to go into the kitchen to make a cup of tea.

Let's revert back, however, to how to operate a stop-loss system in a conventional portfolio of shares. There is a dilemma, which is to set an effective stop-loss policy that is tight enough to curtail losses when things go bad, but not so tight as to sell money-making investments prematurely.

It's a completely different matter if you buy a share that, a month or two later, sees management make a negative trading statement. Here, the story has changed. The share does not have the same fundamentals you started out assuming. Stop-losses are designed to take you out of the share without further ado at times like this.

Tricky decision

It's a trickier decision when the setback that causes you to lose money has been prompted by a setback in the wider market. I once bought the leading property group Land Securities (LAND) when the shares were on a 25% discount to assets after an equivalent fall in the price since the start of 2007. It seemed sensible, but the market setback of 2010 left the shares on a 30% discount to assets.

A stop-loss sale probably isn't appropriate here. The story hadn't really changed that much. Indeed, if you happen to believe that the market is fundamentally undervalued and that the company is solid, then this is the one instance where, rather than selling, it might even be worth buying more.

That's not a recommendation, by the way, but merely an indication that a stop-loss policy has to be judged in the light of how the loss has occurred and the underlying fundamentals of the shares and the market.

Peter says

I've never operated a formal stop-loss policy in my own portfolio, but I do subscribe to the 'pain barrier' method of cutting losses. As I've tried to illustrate here, the idea is to make it as automatic as you can and to admit your mistakes.

But, the key point is whether or not the circumstances behind the investment have altered. If they have, and the shares are lower (and even if they sharply lower), stopping a loss promptly will almost always avoid incurring a bigger loss later.

There is a theory that growth stocks should always be sold if they fall 15% from an all-time high. I'm less certain whether or not that rule should be applied automatically, but it is a useful prompt to ask yourself that all-important question: "Has the story changed?".