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What’s a ‘stop loss’? - Views on News from Equitymaster
 
 
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  • Sep 27, 2004

    What’s a ‘stop loss’?

    When one first starts investing in equities, we come across various terms that are part of the market jargon. Sometimes we are hesitant to ask the meaning of these terms. ‘Stop loss’ is one of such terms.

    While brokers, traders and analysts commonly use it, this article will try to throw some light on what is this concept and why is it being used.

    All of us invest in stocks with the expectation of a gain. We look at companies, their financials, hear the management speak, look at sector potential and arrive at our investment decision. While most of us have a target price in our mind, there is almost no thought given to the fact that the decision to invest may be wrong and one may start losing money on the stock.

    So, what happens when a stock actually starts to head downwards, contrary to the expectations of a gain? Here, there are two common approaches that an investor may take. One, he/she may exit immediately and book a loss. The second approach is that he/she may hesitate to book a loss and decide to hold on to the stock till the time they break even.

    Both approaches by themselves are not entirely correct. When one does start losing money on the stock, they must revisit the basic assumptions they had made while investing in the stock. What has changed in the macro environment for the company? See if the assumptions still hold good. If not much has changed in your assumptions and you are sure that your research still holds good, then may be it’s a good time to buy more and lower your average acquisition cost.

    However, while taking any decision, the time factor too is very important. Suppose, you had invested the amount with a one-year view and after that you had planned to utilise this amount for some other personal use. In that case, even when you find your assumptions to be true, you have to analyse whether your stock will start making money before the year is over.

    A ‘stop loss’ approach comes in handy in such times. Stop loss is basically an approach where you, the investor, arrive at the percentage you are willing to lose on your investments based on your risk appetite. While all of us invest in equities with the expectation of an ‘upside’, it is prudent to look at the ‘downside’ you are willing to risk. Stocks, after all, are inherently risky instruments.

    Say you identify stock X that is trading at Rs 100. Your research tells you that this stock has the potential to touch Rs 150 in about 2 years. At the same time, it is prudent to analyse what percentage of your investment are you willing to risk. Suppose, you realise that losing 50% of your investment is not what you have in mind, then it is appropriate for you to set a ‘stop loss’ limit. For example, based on your personal considerations, you do not wish to lose beyond 20% of your capital invested. In such a case, your ‘stop loss’ should be Rs 80. If the stock touches Rs 80, you exit based on your risk appetite. If you have decided to use the ‘stop loss’ approach, use it with a strict discipline and adhere to it.

    In our view, the idea is not to get married to the stock. At the same time, one should not run scared and exit, when your investment starts losing money. To avoid taking a wrong decision, it is better to do your homework and thoroughly list down your assumptions. This will enable quick decision making (whether to book a loss or to buy more at lower price) when your investment is showing a loss.

    We leave you with parting words by Mr. Warren Buffett: “Unless you can watch your stock holding decline by 50% without becoming panic-stricken, you should not be in the stock market”.

     

     

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