Stop-loss is a strategic device

Setting one forces you to consider the chances of losing money

Market traders use all sorts of stock-picking systems ranging from the exotic to the rational. Some decode lunar cycles, others toss darts at newspapers, while the rational look at price-volume changes and dissect news for potential price-impacts.

All successful traders have one thing in common. They use stop losses. There is a survivor bias here - traders who don't set stop losses tend to get wiped out and leave the market. People set stops at different levels and in different ways depending on individual risk-appetites and preferences.

Long-term active investors also pick stocks according to many different criteria. Some are fundamental in approach but growth-oriented. Others look for value. Some buy stories with promise even when the current financials don't justify it.

However, active long-term investors generally don't use stop losses. Some benchmark their portfolios to indices but that is different. Most active long-term investors don't have a set strategy for controlling losses in case decisions go wrong.

This is an odd gap in investing logic. A long-term investor is taking high risk bets over a long timeframe. Being a buy-only, long-term player is less risky than being a short-term buy/sell trader, but it is still quite risky. The investor is not leveraged and he doesn't short, which means less risk than in trading. But an investor is also prepared to leave money parked in risky assets over very long periods. Even the most stable of stocks will see large price-swings, given enough time. There will be times when the long-term investor suffers large capital erosion and his returns may be negative for years.

It is also inevitable that he will make mistakes every so often. Even the best investors tend to be wrong at least one-third of the time and usually more often than that. It is perfectly possible to end up with two-thirds of a portfolio doing well, while still suffering an overall loss because one-third is doing really badly.

How does an investor deal with such situations? I've never seen very coherent answers in the literature.

The trader's stop loss is a mechanical device. The details are decided before the trader takes a position. If the stop is kept with discipline, losses are always limited. Without such a mechanical loss-control device, an investor could, in theory, gradually lose all his capital. In fact, many investors, who bet heavily on IT in 2000, or real estate in 2008, did lose 85-90 per cent.

Apart from mechanical utility, there are two behavioural advantages to setting stop losses. First, the very act of setting a stop forces even the highly optimistic to consider the chance of losing money. This is healthy, given the inherent risks. Second, if a crisis occurs, the trader doesn't need to think about what to do - the decision is already taken.

Controlling loss in a long-term portfolio is obviously not as easy as setting mechanical stop-losses.

But every investor has an individual pain limit - a point where losses become uncomfortable. It makes sense before buying to consider typical situations. Decide what you will do if the stock falls say, 25 per cent from current levels. Will you average down, sell out, or ignore the situation? Write down your thoughts and follow your own instructions if the situation arises.

A comparison with a benchmark index is another filter. Put some thought into picking the right index for your portfolio. There is not much point comparing a bunch of small caps to the Nifty. Also, compare all businesses to peers.

If the portfolio is doing seriously worse than the benchmark, there's something wrong with the investment style. Assuming the portfolio is not under-performing the benchmark, it is still worth reviewing individual stocks. Ideally, keep notes on why you bought every stock and if the variables change, or new information is available, review. If a stock is doing worse than expected compared to the index and its peers, dig for more information.

Above all, be prepared to admit your mistakes. This is a blind spot with all investors. Since an experienced investor does due diligence and has logical reasons for buying, he also tends to become over-attached to the stocks he's bought.

No matter how exhaustive the analysis or solid the logic, stocks can move the wrong way for random reasons, or due to concealed weaknesses that don't show up in financials until too late. Getting caught in such situations sometimes is inevitable. We all end up learning from our mistakes. If you have loss control mechanisms in place, the learning process will be that much less painful.