November 2011
Vol. 4 No. 10  
in this issue

 

Stop-Losses 101







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Daruma Asset Management, Inc.
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Founded in 1995, Daruma Asset Management invests in high-conviction portfolios of no more than 35 stocks.

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Welcome!

A stop-loss strategy may seem like a no-brainer. After all, everyone hates big losses, so why not have a stop-loss in place? Today's newsletter, with an assist from our friends at Cabot Research, explains why there may be more lost than won when you "Stop in the name of gains!" 

(To listen to this month's newsletter, click here.)

All the best,
signature - Mariko
Mariko O. Gordon, CFA
Founder, CEO and CIO
Daruma Asset Management, Inc.

articleOne
Stop! In The Name of Gains

I was looking forward to my first soccer game in a while last weekend, now that both of my boys are away at school and my weekly attendance at the Church of Soccer has plummeted. The occasion was Parents' Day at Middlesex, where my oldest, Haden, is a high school senior.

All the players were gung ho. The soccer moms? Not so much. It was cold. It was windy. It was pouring. Six inches of snow were headed our way.

As I went from merely wet to drenched, I channeled Uri Geller and willed the game clock to speed up by means of telekinesis. (No luck.) I then tried creating a rift in the space-time continuum so as to jump into the future. (No dice - not enough anti-matter on hand.) Finally, I considered shimmying up a pole and sabotaging the game clock. (Bad idea, for many reasons.)

As the game dragged on, not only did I question the depth of my affection for my son but I started ruminating on all the miserable soccer games I've had to endure over the years.

Games on the fringes of a hurricane; games with incompetent or crooked refereeing; games in which our team was shut out and demolished, with goal after goal racked up by the bad guys.

And speaking of the misery of being shut out, I thought back to when the kids were small and their games were all about having fun and building character rather than winning. The leagues even had a "mercy rule" - when one team is beating another by more than five goals, the game ends, no matter how little soccer has actually been played.

And, because my thoughts rarely stray far from work (even when I'm having fun getting soaked and chilled to the bone), the mercy rule in soccer led me to ponder the investing world's equivalent: the stop-loss rule.

According to InvestorWords, the definition of a stop-loss order is as follows: "A stop order for which the specified price is below the current market price and the order is to sell."

It's a mechanistic rule that forces you to sell and lock in a winning position's gains before you squander them by round-tripping the stock, or to sell a losing position before you lose your shirt. Or, as Michael Martin (The Inner Voice of Trading) puts it, "cut your losses at the knees before they cut your throat."

In either case, the point is to override potentially faulty human judgment by taking emotion out of the sell decision.

Sophisticated investors, of course, know that money-losing positions are an occupational hazard, but big losses make everyone, including money managers, nervous. Trust me on this one. I watched a pension fund board disembowel a money manager for averaging all the way down in Enron, an experience that made me seriously consider switching careers and becoming a macramé instructor.

So having a stop-loss strategy would seem like a 100% no-brainer for all concerned, clients and money managers alike, right?

Not so fast, Nellie.

At least, not according to the fine folks at Cabot Research, who are experts in where the rubber of behavioral finance theory meets the road. Cabot measures how real managers make buy and sell decisions and how good those decisions are. And according to Cabot's Hal Haig, after analyzing over 100 portfolios, most managers would not be helped by a stop-loss rule. (Though some would indeed benefit by as much as 300 basis points a year.)

The rub is that while automatic selling may help in the short run, it may not help in the long term. Some of those losers bounce back. According to Cabot, when you redeploy your capital into other positions following a stop-loss sell, you will often do worse than if you had held on for the longer ride.

They've tracked manager behavior across all sorts of styles, turnover rates and market cap sizes and have concluded that most professionals do a pretty good job of determining when to sell substantial losers and when not to - that's what you're buying when you hire an active manager.

In our case, while we don't have a rule that says we must sell when a stock declines by a certain percentage, as bottom-up small and smid-cap stockpickers, we review anything that's down 15% or more relative with an eye to adding more or questioning our sanity, and then give ourselves 90 days in which to make a decision.

The idea being, not making the right decision from time to time is inescapable, but doing nothing is unpardonable. Either it's a buying opportunity or it's a mistake. It's not a bury-your-head-in-the-sand moment.

On the question of stop-loss, over 16 years, some of our big winners, those held over multiple years, have often started with a bobble or had a bobble mid-holding period. The big losers we ditched, on the other hand, continued to underperform on a relative basis, by and large.

As to last weekend's miserable soccer game, it was just as well that I didn't pull the plug on the game clock or that there isn't a mercy rule for weather. The Middlesex Zebras came from behind 0-1 to win 3-1, with Haden scoring a goal (with his left foot, no less!).

In soccer, as in investing, sometimes losers left in the game will work their way back into the winner's circle.





articleTwoStop-Losses 101

Of all the articles I've circled, dog-eared and highlighted on the topic of stop-losses, these are among my favorites. Click the titles below to learn everything from how to measure the impact of a stop-loss rule to the role of regret in investment decisions.

When Do Stop-Loss Rules Stop Losses?
By Kathryn M. Kaminski and Andrew W. Lo

Once Burned, Twice Shy: How Pride and Regret Affect the Repurchase of Stocks Previously Sold
By Terrance Odean, Michal Strahilevitz and Brad M. Barber

Regrettable Choices
By Michael Ervolini



articleThreeFrom Travolta to Rocky... Our "Greatest Comebacks" Challenge

let's make better mistakes tomorrow
Soccer and investing aren't the only domains in which incredible comebacks are possible.

Who can forget John Travolta's career turnaround? Rocky Balboa's rise from the ashes? The fabled tortoise's come from behind victory? Where would they be if they had cut their losses and quit the game instead of working their way back to the top?

How about you? We want to hear your favorite comeback stories! Reply to this email with your favorite - in any category.
We'll select two winners, both of whom will receive a signed, limited-edition "Let's make better mistakes tomorrow" print by artist Mike Monteiro.




© 2011 Daruma Asset Management, Inc.


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