The nuts and bolts of investing

Jan 21, 2015

- By Bill Bonner

Bill Bonner
Rancho Santana, Nicaragua

Dear Diary,

Investors returned from a 3-day holiday and found both stocks and gold right where they wanted them. Neither registered any change yesterday. So let's return to the nuts and bolts of investing.

Take a look at your own portfolio. Now, imagine how much better off you'd be if all those 50%...60%...80% losses were removed. You could do that by using a simple trailing stop.

That's the easy part.

"More important," says Richard Smith, "is that trailing stops allow you to take full advantage of your winners.

You buy a stock. It doubles. What do you do? Many investors would sell, feeling that they had made a good profit; why be greedy? Often, they then watch as the stock goes higher and higher and higher as they sit on the sideline grousing about having gotten out too soon.

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Old timer Richard Russell frequently tells the story of how he invested in Buffett's Berkshire Hathaway in the early '70s. The stock doubled and he sold. He has been kicking himself ever since. The Class A Berkshire Hathaway shares, which Buffett bought for $11 in 1962 now are worth about $227,000 each.

"The most important phenomenon in investing is one most investors aren't even aware of," says Richard. "When a stock goes up you are pleased...but the effect grows weaker over time. Emotionally, investors become a little blase about it. But when a stock goes down, the pain increases the further it goes. Investors become more concerned, emotionally, as their losses increase. So they tend to sell their winning positions out, easily. As for their losses, they stick with them hoping to get back to breakeven. In other words, they do the opposite of what they should - they cut their winnings and let their losses run."

Stop losses are a tool you can use to help fix this problem. You set a stop loss order at a level that leaves you with a risk you can tolerate. That will keep you from taking a big loss.

And when you get a stock that is a winner, rather than sell it out, just put on a stop loss and let it run. Winners are winners for a reason. Often, they will be far bigger winners if you stick with them. Stop orders force you to cut your losses. And they permit you to hold onto your winning positions without the risk of giving up your gains.

Richard figured this out by analyzing the portfolios of newsletter editors, George Soros, Jim Cramer and others. In almost every case, stop loss orders made a substantial improvement in performance. Then, he turned his attention to improving the standard stop loss order. What he came up was a "smart stop," one that was tailored to the individual investment.

"Not all stocks are created equal," Richard explains. "Some are very volatile and some are not. You don't want to get stopped out of a very volatile stock just because you set your stop too tight. And if you put your stop too loose, on a stock without much volatility, it won't serve its purpose."

Richard came up with a formula for the perfect stop. They vary from 10% to as much as 80%. Using these 'smart stops' improves the results.

For example, a study of Steve Sjuggerud's 'True Wealth' portfolio, since 2000, showed the following results:

Putting $1,000 into each of Steve's recommendations since 2000 produced about $30,000 in profit by 2014. Adding a simple 25% trailing stop turned the $30,000 into about $50,000. Then, using 'smart stops' raised it to $55,000.

Then, Richard went one...or two...steps further. He developed a formula to tell you when you should get back into a stock after getting stopped out. He calls it his 're-entry rule.' Adding his re-entry rule to the formula puts another $15,000 to the bottom line. Altogether, his tools turned a $30,000 profit into a $70,000 profit - on the same basic trade.

For us, the conclusion is simple. Stop losses work, for most people, most of the time.

Bill Bonner is the President & Founder of Agora Inc, an international publisher of financial and special interest books and newsletters.

Disclaimer: The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and have not been authenticated by any statutory authority. The author and Equitymaster do not claim it to be accurate nor accept any responsibility for the same. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. Please read the detailed Terms of Use of the web site.

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