Cutting Losses 101

Here are some simple risk-control rules commonly used by professional traders:

Decide when to sell before you buy: Buying is often easier than selling. When do you cash in if your stock goes up? When do you sell if it craters? Most everybody has an ouch point—even a buy-and-hold investor. Is it after losing 60 percent of your assets? Ninety percent?

The pros tend to avoid this conundrum by picking their selling point before they buy. It’s their way of admitting they don’t know what’s going to happen in the market.

A simple way is to look at a chart. Take the S&P/TSX composite index. It bottomed at 7647 in late November and has since gained 1,000 points. Not bad. If I were to buy it today, I might place my sell point (often called a “stop”) below a recent major low (like 7647) or the 20-day moving average.

Traders often set stops a little below such levels because they don’t like to get stopped out by regular market noise; they want to sell only because of a serious breakdown.

I use the same rule to figure out when to sell a winning stock. For example, I might place my stop one or two percent below a stock’s 20-day moving average and adjust upward as the price rises. That’s called a trailing stop.

The exact stop level can be adjusted based on the timeframe of the investor. A long-term purchase could use a stop 10 percent below a major multi-month low or the 50-day moving average; a very short-term trade may use a stop one percent below a recent low or the five-day moving average.

(You can view free charts of Canadian and U.S. securities, including nifty indicators like moving averages, at StockCharts.com and Yahoo! Finance.)

Size matters: Knowing when to sell tells me how much money to risk on an investment. A common rule-of-thumb is not to risk losing more than one or two percent of total assets in any single trade.

In our TSX example, say I buy the index at Tuesday’s closing price of 8742 and my stop is 7532. That equals a 14-percent loss if my trade goes sour and my stop is triggered.

A little math tells me I should invest no more than 14 percent of my portfolio in this trade if I can’t stomach losing more than two percent of my total assets (100 percent divided by half of the 14-percent potential loss).

Diversify: Stops and appropriate positions don’t help me much if I’m 100-percent invested in a single sector that goes belly-up. If my stops are hit at the same time in 10 energy companies, I’ve just lost 20 percent of my Freedom 55 fund. Sayonara, beach house.

That’s why pros often put no more than 20 or 25 percent of their assets in any one market.

Cut your losses: “To make great sums of money,” trader Paul Tudor Jones once wrote, “you first have to learn how to lose much smaller sums of it when you’re wrong.”

I had my own lesson about this last fall. I often invest with a mechanical investing system that I developed. Last summer, the market data started to hit extremes it had never seen before. Signals were often wrong and costing me money. I wasn’t down as much as the broader market, but enough to make me take a closer look at my approach to risk control.

I realized I had no rule for when the market data was acting completely out-of-line with historic precedents.

To account for this I adopted a slightly adapted version of another commonly used trading rule: If my portfolio loses more than six percent in any four-week period, I sell everything and go to cash. Call it a time-out for a misbehaving market.

I adopted this rule just in time to sidestep the worst of the market carnage in October and November.

When the time-out was over, I was set to jump back into the markets just as they rallied powerfully in late November and December.

Has the market finally bottomed? I don’t know. I do know the market can turn on a dime. And if I want to survive, I must, too.

Which brings me to another good trader’s rule: get a little Zen. Lose the pride and don’t be sentimental about an investment. It’s money, after all, not romance. Emotions are the worst enemy of an investor. If I’m wrong, I try to learn something and move on to the next idea. I think of my loss as a tuition fee.

This approach was captured nicely in the movie Kung Fu Panda. “Master!” says the kung fu teacher. “I have… very bad news.” “Ah, Shifu,” the wise old turtle replies. “There is just news. There is no good or bad.”

Hey, that really is a wise old turtle. Perhaps Mr. Buffett could use a kung fu lesson. Perhaps we all could.