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How Stop-Loss Limits Help Active Investors
Passive portfolio management enjoys several advantages, perhaps most notably low fees. In some circumstances, it could also be more tax-efficient, since there is less buying and selling, meaning investors don’t incur capital gains very often. For these reasons, it aligns perfectly with the aims of a wide universe of investors, including those just starting out and others that may not have large portfolios.
But for anyone with bigger balances, a more active approach is likely a better way to go.
The reason is investors using passive strategies tend to stockpile cash during bull markets, fearful of the havoc a sudden drop in equities would cause. And while that approach may cushion some of the blow in the event of large losses, it also means passive investors are frequently underinvested during more buoyant times and thus likelier to miss out on gains.
Contrast that with someone owning various individual positions who when any of those holdings drops approximately 15% against their cost basis (their purchase price), they sell.
Not only does this strategy better position investors to potentially maximize gains (provided that their allocations are well thought out), but it’s also a prescribed way to limit more severe drawdowns during bear markets and drive tax-efficient investment returns.
Further, it melds together principles that are fundamental to financial planning: asset allocation, risk management and cash flow management.
Indeed, using a loss limit sell rule both minimizes downside and takes all the guesswork out of when to sell, which helps to ensure investors hold only their strongest positions and means they should have enough “dry powder” to look for other opportunities.
At the same time, it guards against rash decisions, since this example is not triggered when a stock drops 15% from the stock’s all-time high, only when it drops 15% from the time you bought it. Those are two distinct concepts entirely, and knowing the difference is critical to boosting portfolio value.
Here are some things to know about loss limits:
- Avoiding mistakes.
- When to buy.
- Stocks to watch.
Avoiding Mistakes
This approach also may protect against the unintended consequences that are inherent to common diversification strategies. Many passive investment managers, for instance, lean on international and emerging market equity exchange-traded funds in the name of trying to achieve balance over the long term.
There’s nothing wrong with that in theory. But what retail investors need to understand is that these volatile asset classes are positively correlated with U.S. equities and tend to become even more so during down markets. That means they’ll likely hit the 15% sell threshold much faster than domestic stocks.
This is important because when a manager has exposure to these asset classes and neither cares nor is aware of what the cost basis of those ETFs is relative to their other holdings, the manager is failing to make the most of your money, especially when markets hit a rough patch. That’s a high price to pay just to achieve diversification for its own sake.
When to Buy
A per-position loss limit of about 15% is not only a good way to mitigate losses, but it may also ensure your portfolio evolves with markets. Normally, any time a stock falls by that amount, it’s worth trying to find out why.
Are its revenues reasonably healthy despite the drop? What about its profit outlook? Is there any reason to believe long-term economic trends could provide a tailwind going forward?
Of course, these are not normal times. So, asking questions about business fundamentals today will require examining the environment through the lens of the ongoing coronavirus pandemic.
Stocks to Watch
With that in mind, it probably makes sense to focus on the factors that seem most obvious. Among them are that bond yields will likely remain low for the foreseeable future, meaning bond investors may become frustrated and eventually start looking for bond-like equities.
That would bode well for stocks with higher dividend yields, as well as publicly traded real estate investment trusts, referred to as REITs.
Pharmaceutical firms such as Bristol Myers Squibb Co. (ticker: BMY) and Merck & Co. (MRK) are names to consider. Also look at Crown Castle International Corp. (CCI), a REIT that is essential to the U.S. communications infrastructure.
To be sure, certain other stocks will rise due to how global stay-at-home orders and social distancing have changed consumer behavior, including Zoom Video Communications (ZM), even as it’s facing a series of challenges now that its platform has become massively popular.
Eventually, this health disaster will subside and the market will return, just like it always does. And when that happens, a new assortment of stocks will no doubt become 15% rule candidates.
Stick to this approach and you will be able to create an efficient portfolio that accumulates wealth, instead of one that sits on cash at the worst possible time.
