I’m a perfectionist.
I like my steak with just a hint of pink. Anything more or less, I give it right back to the cook. (As a result, Cecily stopped making steak for dinner a long time ago.)
I like an organized office … but organized MY exacting way. Anybody who messes with my office had better watch out. (I’m talking to you, Annie!)
I bring this up not because I’m in a confessional mood. It’s because when it comes to my portfolio, my perfectionism is something I’ve had to get over – and something you’re going to have to get over too if you want to have a reasonable chance of success in the stock market.
Striving for a perfect portfolio – with every investment a winner – is … well … a mistake. Let me explain.
Of course, you never make an investment with the intention of losing money. But if you are determined to make each and every one of your investments a winner, you’re doing yourself a grave disservice. Because if you feel you always have to be right, it will be awfully hard for you to sell a money-losing stock for a loss. You’ll hold onto it … waiting for it to reverse direction and start to make money.
But what if it doesn’t turn the corner? What if it just drops … and continues to drop? In that case, what would have been a minor annoyance had you exited this stock at, say, a 25% loss (more on this in a moment), now threatens to put you in a hole that is very difficult to climb out of.
You may find it hard to believe that stretching the time you hold an investment can make such a big difference, so let me give you an example.
Let’s assume you’re looking for 15% annual gains on your investments. You’ve just invested $1,000 in a stock, but it’s gone south. So you sell the stock at a 25% loss, and you’re down $250.
Meanwhile, you’ve also invested in two other stocks at $1,000 apiece, and have made an average of 35% ($700) on them.
On your total investment of $3,000, you’ve made $450 (the $700 minus the $250) – a 15% return.
Now let’s see what happens if you hold onto your losing stock a bit longer before getting out – until your $1,000 investment drops 50%. You’re now $500 in the hole. And that means you’d have to make almost a 50% average return on your two other $1,000 investments to have a 15% return on your total investment.
Making 35% annual gains on stocks is no slam-dunk … but it’s not an outrageous feat either. Making 50% … that’s another story.
But it could be even worse. Let’s say you let your first stock drop 75% before selling. You would have to make 60% on your other two stocks just to make a 15% return on your overall investments. While 60% is possible, it’s extremely hard to do. So you’ve put yourself in a position where you have to make exceptional stock selections just to make ordinary average returns.
Investing in stocks does not have to be that difficult.
Aside from making you hold on to your losers too long, there’s another reason that trying for perfection with your investments doesn’t pay: It’s not a realistic objective. And if you think it is, you are bound to lose confidence in your ability to make good stock selections – or good investments of any kind.
Value investors (like me) expect to lose a little in the short term … because value stocks sometimes go down before they go up. But even value investors have to be willing to get out.
Well, then … how do you know when to get out?
The idea is to protect yourself from major losses. And the general rule I use – to get out at a 25% stop-loss point – should protect you from any lethal blows to your portfolio.
If you are investing in a stock that (you think) has a very high upside, you may want to give it a little more rope.
Let’s say, from the research you’ve done, you’re convinced that a stock could double in price within the next year. In other words, it could go up 100%. In that case, it’s not too risky to let it slide about a third of its expected upside. In other words, to set a 33% stop-loss point for the stock.
You can also be a little more lenient with a dividend-paying stock, because you’re getting a cash payment on that stock every quarter (whether the share price goes up or down).
Let’s look at a specific example. If you invest $1,000 in a stock that gives an 8% annual dividend, you will get $80 back if you hold on to the stock for a full year. Even if your dividend-paying stock loses 25% of its share value within the first 12 months of your investment, you lose only 17% after getting your four quarterly dividend payments. If the dividend is 8% and the share price falls 8%, you’re even. So in this case, a 33% loss point would be equivalent to a 25% loss point of a company not offering dividends.
If you have the discipline to follow a stop-loss system like this, you can have twice as many losers as winners – and still be an incredibly successful stock investor.
Let’s return to our earlier example of investing $1,000 in three stocks. Only this time, you follow your stop-loss system. When two of the stocks start to lose money, you sell them when they fall 25% below what you paid for them. You’re out $500.
The third stock, however, goes into a steep climb … and keeps on climbing until it’s gained 100%. You’ve earned $1,000 on this stock – and now your total returns on the three stocks are $500 (a $1,000 gain minus a $500 loss). So on your initial $3,000 investment, you have made a 16.6% overall gain.
You’ve exceeded your minimum objective of earning 15% per year on your investments, despite having more losers than winners.
[Ed. Note: Andrew Gordon, ETR’s financial expert, is the editor of The Skeptical Advisor, our investment newsletter. Check it out at http://skepticaladvisor.com.]
“The pursuit of perfection often impedes improvement.”– George Will