| What do the "experts" say about stop-losses? | | | | 4% for most O'Neil accounts and 1% to 5% for |
| Granville, Weinstein, Dines, Magee, Crane, Edwards, | | | | most Zweig accounts. Again, the key concept is |
| Zweig, O'Neil, Wycoff, Sperandeo, Bernstein, | | | | not the percentage loss permitted by a stop-loss but |
| Schwager, Murphy, and many others agree that | | | | the total impact on the whole portfolio of any single |
| stop-losses are an important part of any investment | | | | stopped-out stock. |
| discipline. Some investment professionals, like William | | | | Most of the best investors in the business allow a |
| O'Neil of Investors Business Daily, say that a person | | | | single stock to have a maximum negative impact of |
| should sell any stock that drops 8% below the buy | | | | 4% to 5% on the whole portfolio. Many of the |
| price. They also maintain that an investor should | | | | best traders are much more restrictive than this. |
| hold about 5 stocks. That means a drop of 8% | | | | For example, traders try to keep the maximum |
| represents a hit to the portfolio of 1.6% for any | | | | negative impact on a portfolio limited to no more |
| single stock that drops 8%. O'Neil does allow | | | | than 1%. The amount of drop they permit an |
| investors with very large portfolios to hold a few | | | | individual stock is loosely determined by the number |
| more stocks. However, a person with $3000 is | | | | of positions designed into the portfolio (it is related to |
| advised to hold no more than 2 stocks. Therefore, | | | | the size of the position relative to the size of the |
| these smaller investors are being advised to tolerate | | | | portfolio). For example, a 4% to 5% drop in the |
| a 4% impact on their entire portfolios when a stock | | | | entire portfolio would result if one stock dropped |
| is "stopped-out" with an 8% loss (8% ÷ 2 = 4%) in | | | | 60% to 75% in a 15-stock portfolio, 40% to 50% in |
| addition to a 3.7% brokerage commission for the sale | | | | a 10-stock portfolio, 32% to 40% in an 8-stock |
| (Schwab's standard rate). Older editions of his book | | | | portfolio, 20% to 25% in a 5-stock portfolio, or 8% |
| imply these brokerage rates (the cheaper on-line | | | | to 10% in a 2-stock portfolio. These figures show |
| rates came later) because they say the investor | | | | the benefit of diversification. It takes a 60% drop in |
| might save as much as 50% on commissions by | | | | a 15-stock portfolio to do the same damage as an |
| using a discount broker (Schwab's normal discount | | | | 8% drop in a 2-stock portfolio. Though a 75% drop |
| rates are about 50% off standard brokerage | | | | seems extreme, in the context of a 15-stock |
| rates). In his prime, O'Neil was one of the most | | | | portfolio it is consistent with the maximum declines |
| successful short-term stock traders. His strategy | | | | allowed by the disciplines of O'Neil, Zweig, and many |
| recommends that investors focus on only a few | | | | others (in terms of its impact on the whole |
| stocks, watch those stocks carefully, and implement | | | | portfolio). More typical (for Zweig, O'Neil, et al) are |
| a strict 8% stop-loss discipline. This school of | | | | the portfolio declines of 1.6% to 2% that occur when |
| thought is dominated by short to intermediate-term | | | | an individual stock drops 24% to 30% in a 15-stock |
| traders. Granville agrees that such traders, who | | | | portfolio, 16% to 20% in a 10-stock portfolio, or 8% |
| concentrate on a handful of stocks, should maintain | | | | in a 4 or 5-stock portfolio. As used here, a |
| close stops because the impact on the whole is | | | | "15-stock portfolio" refers to the size of each position |
| greater if any one of the stocks gets out of | | | | relative to the whole. The portfolio does not have |
| control. He points out that a sharp reaction in just | | | | to have 15 stocks in it at the time to be a 15-stock |
| one of six stocks could wipe out the gains in the | | | | portfolio. The phrase means that each position is |
| other five. A portfolio manager with a perspective | | | | about 1/15th of the portfolio. That is, a portfolio of |
| very different from that of O'Neil is Marty Zweig | | | | 3 stocks is still a 15-stock portfolio by design if each |
| (there is a point to all this, so please keep | | | | of the three positions is about 1/15th of the assets in |
| reading). | | | | the account. The other 12 positions are simply |
| Marty Zweig has had one of the best all-time track | | | | allocated to cash. In a 10-stock portfolio, each |
| records as a money manager. What does Zweig | | | | position represents about 1/10th of the total assets |
| say? With regard to diversification, he cites | | | | in the account. |
| academic studies showing that most of the | | | | The individuals I have cited fairly well represent the |
| advantages of diversification can be achieved by | | | | range of thinking of well-known and respected |
| holding 8 stocks in 8 different industries. However, | | | | authors in the field. O'Neil believes that the typical |
| Zweig would try to buy 4 stocks for a portfolio of | | | | individual investor who closely monitors and actively |
| $5,000 or as many as 33 stocks in larger portfolios. | | | | manages his account should limit himself to 5 stocks |
| With regard to stop-losses, in Winning on Wall Street | | | | (no more than 8 for large accounts). This number is |
| Zweig says that it won't hurt a portfolio much if you | | | | easier to monitor and it forces a sale of weak |
| get stopped out for a 15% loss, but that 20% is | | | | positions in order to buy stronger ones. Zweig, on |
| about all he would tolerate. He usually his places | | | | the other hand, uses a considerable amount of |
| stops 10% to 20% below his purchase price, | | | | technology in tracking his stocks. Hence, his |
| depending on his analysis of the stock's trading | | | | disciplines work well with more stocks in the |
| pattern. | | | | portfolio. Our own technology, disciplines, and |
| Who is right? In a sense, they both are. If a | | | | procedures do the same for us. Thus, we can |
| person has only 5 stocks, and he does not know | | | | choose how focused or diversified we want to be. |
| how to interpret chart patterns, a purely mechanical | | | | Diversification is the key to more flexibility. In |
| 8% stop-loss makes sense. However, there are | | | | volatile markets, a stock may drop 9% or 10% and |
| times when an 8% stop would sell a stock just | | | | then quickly rebound to a 15% profit. A purely |
| above strong secondary support. In such cases, it | | | | mechanical system might take an 8% loss on such a |
| might be more prudent to wait for the probable | | | | stock when a 15% gain was possible. The more |
| rebound. That's how we once turned an 8% loss in | | | | diversified the investor, the more a stock can be |
| Caterpillar Tractor into a 35% gain (in this case, | | | | allowed to decline before the investor has to eject it |
| substantial support was well below the 8% loss level | | | | from the portfolio. That, in turn, enables the |
| but the overall price/volume pattern suggested | | | | investor to reduce the number of unnecessary sales |
| strongly that the support would hold and the stock | | | | at a loss by basing decisions about where to place |
| would resume its up-trend). | | | | stop-losses on an evaluation of the support zones |
| A person with 12 stocks who orders a 20% | | | | (regions where buying activity exert upward |
| stop-loss (as per Zweig) would experience a "hit" on | | | | pressure) for each stock. It frees the investor from |
| his entire portfolio of 1.66% if he is stopped out of | | | | having to order mechanical sales at, say, 8% below |
| any single position. However, Zweig also permits a | | | | the purchase price. If the portfolio is designed to |
| very small portfolio to have only 4 stocks. In this | | | | have 15 positions, a stock can be given a little more |
| case, his 20% stop-loss has an impact on the total | | | | latitude if it is falling and there is support nearby. |
| portfolio of 5%. Both of these figures are similar to | | | | Even a 15% loss in a single stock will impact the |
| the figures proposed by O'Neil. Each has stop-loss | | | | portfolio only 1%. |
| parameters that are similarly related to the amount | | | | Copyright 2009, by Stock Disciplines, LLC. a.k.a. |
| of diversification recommended. Triggered | | | | StockDisciplines. |
| stop-losses will impact an entire portfolio 1.66% to | | | | |