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Savings Experiment: Snow RemovalLast year global stock markets lost $29 trillion in value -- falling 42%. And although it does not get much media attention, there is something that investors can do when the stock market moves against them. They can set stop losses on their stocks which limit how much money they can lose. Specifically, if an investor buys a stock at, say, $20 a share, he or she can issue a limit order which requires the broker to sell the stock when it declines to a lower price, say, $18. Such a limit order would limit the investor's loss to 10%.
This comes to mind in considering why the average stock in my investment newsletter gained 15% in 2008 when the S&P 500 fell 38.5%. My monthly newsletter analyzes broad economic trends and bores into specific industries. It also picks three stocks each month for subscribers to consider. During the first half of 2008, the energy and commodities stocks mentioned boosted its performance to +29% through the end of June. Then the bottom began to fall out as commodity prices tumbled and the financial services industry collapsed.
Thanks to the 2% stop loss rule -- which automatically sells any stock that falls 2% below the price at which it was mentioned in the newsletter -- the low point for the year was -1% at the end of October. By the end of 2008, only four of the 36 stocks mentioned remained in the portfolio. However, thanks to a surprising boost in one stock mentioned at the end of October and the three stocks picked at the end of November, the average stock was up 15% by the end of 2008. What were the three best performers?
- URS Corp (NYSE: URS) rose 22% from $33.41 at the end of November to $40.77 by year end. URS -- a design and construction firm, won a $3.3 billion contract in December and may be perceived as well positioned to take advantage of an infrastructure stimulus package expected in early 2009;
- AAR Corp (NYSE: AIR) rose 15% from $15.99 at the end of October to $18.41. AAR -- which supplies aviation parts -- saw its sales rise 14%, fully-diluted earnings climb 21% and its backlog increase 28% in a December report; and
- Plexus (NYSE: PLXS) increased 11% from at the end of November $15.21 to $16.95. Plexus develops and manufactures electronics telecommunications, medical, industrial, and computer companies.
Without the 2% stop loss rule and some lucky year end picks, this would have been a bad year for my newsletter. The big lesson here is that investors should consider stop losses -- particularly for individual stocks in their portfolio.
Peter Cohan is president of Peter S. Cohan & Associates. He also teaches management at Babson College and edits The Cohan Letter
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Reader Comments (Page 1 of 1)
1-02-2009 @ 11:33AM
Brian said...
Stop loss orders sets up the investor with a false sense of security as the stop loss fails to protect from losses.
1-02-2009 @ 12:01PM
Bill said...
Most brokers avoid stop loss orders because they do not get paid on writing a ticket until the order is executed. Constant rewriting as the market moves up doesn't pay them, a very short sighted attitude. Some brokers cite the times that a stop has been hit and then the market rebounded away from the stop which limited the investor's profits. I admit to these exceptions but that does not negate the stop loss tactic which is aimed at preserving capital.
1-02-2009 @ 12:10PM
Sheldon L said...
While this approach has its merrits, this is in no way a 15% average return.
Please go through the math for us.
Your three best performers did 22% for one month, 15% for two months, and 11% for one month. This means you did an average of 16% for 1.33 months (1/9 of the year) not the year. Divided by 9 that equals 1.78% annualized.
Now you say 32 stocks were sold off in the first 10 months (seems 3 would have been sold in the last quarter, but we'll let that one go) at the 2% stop loss during the year. 2% divided by an average holding period of 5 months = 0.4% annualized.
Therefore your losers were down .04% and your winners gained 1.78% for a net gain of 1.73% over the year minus trading cost NOT 15%.
That is closer to the real picture. And STILL GREAT because break even was darn good in 2008.
Congratulations!
Stop losses work in a down year. In an up year, after the stop loss triggers on the 2% down move, what happens when the stock is up the next day (or afternoon) chasing new highs and you do not own it? This is a very conservative approach that limits upside as well and over the long term cannot beat an index fund.