After beating benchmark returns comprehensively over the past three years, our portfolio has seen a roller-coaster ride so far in 2018. With broader market indices taking a beating and the general market turning choppy, we had to cut losses in quite a few of our recent stock additions.
While most of those stocks might recover and appreciate in future, we stuck to our strategy of cutting losses that has served us well for more than five decades. When a market uptrend reverses and shows signs of distribution, there is no point holding onto stocks that might not even come back to their previous highs in the next uptrend. Well, that’s how the markets are. A leader of the previous market uptrend rarely retains the leadership status in the next uptrend. Arguing with the market at this juncture could cost one a lot of money. And that’s the reason why an 8% stop-loss is much better than sitting in a stock that either corrects 30-40% or remains sideways for months.
Most investing strategies that help make money over long periods might look pointless in the short-term. That’s the nature of stock markets. However, as an investor, one should focus on how a strategy has performed over longer time periods because that’s the best way of incorporating the effects of bull, bear, and choppy market cycles on portfolio returns.
Judging investment strategies based on short-term performance will make you impatient, forcing you to jump from one strategy to another only to realize later that you learned nothing despite being in the market for years. Stock market is a place where money is made and lost. You can’t be winning all the times. Sticking to a proven method and continuously learning from mistakes are the essential ingredients for success in the stock market.
Regarded as one of the greatest investors of all time, Warren Buffett’s Berkshire Hathaway underperformed S&P 500 in 17 out of 53 years during 1965-2017. But, does that make him a bad investor? Certainly not. Eventually, what matters is the quantum of money you make when you are right and the amount you lose when you are wrong.
That’s the reason why CAN SLIM advocates a risk/reward ratio of 1:3 (cutting losses at 7-8% and booking profits at 20-25%). Such a ratio would allow you to earn money even with a mediocre hit rate of 30%. Of course, there will be times when your hit rate would suffer. And that’s likely to happen in choppy and range-bound markets, when the trend is no longer your friend.
During choppy markets, one can consider trimming return expectations. A 1:3 risk reward ratio can be maintained by lowering profit booking and loss cutting levels. This is certainly a good way to handle choppy and volatile markets.
In addition, an investor should also critique all his investment decisions and conduct a post-analysis of all trades at least once a quarter. Experience is the single most important weapon in your armoury. The lessons learnt from your mistakes will help you to evolve and take better informed decisions in future. In stock markets, you gain experience by losing battles. The same experience then helps you to win the war.
Lessons Learnt from Our Recent Mistakes
Paying Heed to Reversals in Weak Market
In the recent sell-off in midcap and smallcap stocks, our risk management rules forced us to cut losses short. Most of the removed stocks had actually moved higher from our add prices and were in gains at one point of time. However, those had to be removed at losses following a heavy sell-off in the broader market.
An important sell signal that serves well in a weak market is selling a stock after it reverses from an all-time high on above-average volume. A downside reversal takes place when a stock runs up sharply intraday, then changes course and ends near the day’s low. It may mean that institutional investors are not enthusiastically coming in to grab shares.
From our portfolio, stocks such as KEI Industries, Intellect Design Arena, GNA Axles, and Thomas Cook (India) reversed after hitting all-time highs last month. When leading growth stocks face selling pressure at new highs and the market struggles to trend higher, we can certainly use the downside reversal pattern to book profits or cut losses much earlier. In a weak market, managing drawdown should always supersede fear of missing out on future gains. You can always get back into a stock when it breaks out again and the market condition turns favourable.
Now, should one make downside reversal as a primary sell rule? Not necessarily. This has to be used as a secondary sell rule in conjunction with the overall market condition. When the market is in a Confirmed Uptrend, you should always give a leading growth stock ample time to prove itself.
Staying Away from Extended Stocks
After undergoing correction from January-March, the midcap and smallcap indices made a smart recovery in April. During this period, we saw some high-growth stocks breaking out to new highs and went on to add them to our portfolio. Names such as Gujarat Ambuja Exports and Som Distilleries had given phenomenal returns in 2017 and those returns had come at a rather quick pace. By the time those stocks broke out, they had advanced over 50% from their 200-day moving averages. While our other stock additions, in which we booked profits, Mindtree and L&T Infotech were also quite extended (+50%) from their 200-DMA, both were large companies and came from a market favourite sector, Information Technology. In hindsight, we should have stayed away from extended names, especially if they were not part of a sector being favoured by the market.
Sticking with Quality Large-Caps Especially During Tough Periods
It is easier said than done. Quality stocks always trade at a premium and are mostly available at or near new highs. Further, we have been seeing those stocks for years, as a result of which we have their lower historical prices at the back of our mind. The anchoring bias makes it even more difficult to buy those stocks at high prices. However, we did not shy away from adding some quality large-cap stocks just because those were highly priced. Names such as Nestle India, Britannia Industries, Bajaj Finance, and Kotak Mahindra Bank have all advanced 10-20% from our add price, boosting our portfolio performance in a rather tough period.
The Bottom Line
The market continues to struggle for direction and could remain choppy in the near term. Amid huge divergence between large-cap and lower-cap stocks, market participants would be better off if they continue to stick with quality large-cap names.
Success in stock market demands continuous improvement. And it is only possible if we are willing to identify our mistakes and learn from them. There is no guarantee that an investor will not make mistakes in future. But, one should be disciplined enough to learn from old ones to succeed in the market.
Finally, to answer the question, if there is anything that is worse than losing money in stocks then it is losing hope!
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