Sunday, December 15, 2013

How to protect your profits

With share prices rising higher and higher in this bull market, so does the risk. The higher the market the closer we’re getting to the next melt-down.  Yet, it is also true that profits tend to escalate in these late stage markets. Everyone is on fire; it is hard not to get dragged along in the frenzy; many investors don’t realize that the high profits being made are not normal.

Then comes the crash – when most investors least expect. “I just started to make profits [yeah because you were out of the market many months ago when you should have been buying] and now you tell me that the market will crash?”
Market timing is close to impossible, but with this rising market there are strategies we may want to deploy as protection against the coming crash, while still enjoying the fruits of the market hysteria. In the coming posts I will discuss:
1.       The emergency break: stop-loss selling.
2.       Selling discipline – once you made a decent profit force yourself to sell by using call options.
3.       Collared options – sell calls and buy puts – put a ‘collar’ around your up and down side.
4.       Take profits and build your cash stack.  Build cash for after the crash!
This post will start with a very simple strategy – Your emergency break: Stop-Loss Selling!
Many people consider selling below the market peak as ‘losing money’ regardless of the fact that even 20% below the peak they still may have a profit compared to their purchase price. This form of ‘investor self-entitlement’ is common to most investors, including myself. We tend to consider pricing at the market peak as the value of our investment even if that price is more based on hysteria (irrational exuberance) than on true business value.
So the stock was worth $30.00 at the peak and now it is down to $25. “Oh I lost $5.00!,” the self-entitled cry. “Really? But you bought at $22. However, if you really feel that way, you’d better sell before the stock falls to $18!" The self-entitled investor replies:  “No, I can’t, I have to recoup my ‘losses’… I’ll hold on.” Next thing you know, the market crashes another 30% and then are in a true loss position. Next  Mr. Investor panics and sells because “it may fall even more”. [But we know better – once a market has fallen dramatically, so has risk!]
This chart illustrates how much an investment has to rise in price (recover) percentage-wise after incurring a loss in value in order to break even.  A $100 investment with a price fall of 10% is worth $90. For the investment to recover to  $100 its price needs to rise by 11.1%. 
When the market falls 10% you need to go up 11.1% to get back to the same price you started. When the market drops 20% you need prices to rise  25% to recover. When the market is down 25% you’ll need to go up 33.3% and when you crash 50% the market needs to go up 100% to get back to where you were (see table above).
 That is why 'buy & hold' is so difficult for so many investors, because by the time you are back to the high of the previous bull market, the media starts hooting and hollering about investors who bought at the bottom and 'made nearly 100% !'  The potential 'buy & holder' feels stupid and discouraged comparing himself with those 100% guys who look like geniuses (although those 'geniuses' didn’t talk about the stocks THEY lost on).
We need a strategy to get out in time and to be able to buy back in at lower prices. But when to sell in a bull market? Well, let’s look at it in simple terms: typically the term ‘correction’ is used in a market that has fallen between 10 and 15%. People get nervous during a correction but the market typically recovers within a week or within a month or two after which the market will go up even higher.
 A bear market officially is called after the market has fallen 20% from its peak - the ‘fall’ occurs typically in stages. In October, 1987, the one day 22% market drop was exceptional – it was the steepest drop in history. Not even Peter Lynch saw it coming. Other than in October 1987, there usually is time to react in a falling market.
So if an individual stock or the market falls 25% from its recent peak , we know that we’re in real doodoo! Do no longer hesitate and sell!
The idea is that even when caught off guard, if you sold at 25% below the previous market peak of a stock or of a stock market (index), then you probably got out in one piece (although with some scars). We know bear markets can go easily down yet another 25% from this point onward (a total drop of up to 60% percent below the peak is possible). Selling at 25% below peak is truly your emergency break!  With discount brokerages it is quite affordable in commissions to sell quickly. You can sell 10 positions for $100 in commissions and thus that is quite doable.
The big problem may be the taxes that you may trigger when selling – in particular capital gains. But it is probably better to pay taxes over profits than losing so much money that you can’t fight another day.  So create a spreadsheet of your stock holdings (similar as the one shown below), enter your purchase price or the last high after purchase (whichever is higher). If you want to use a stop loss of 25% then multiply that price by 1-25% (75%) to get your stop loss price. If the stock hits your stop loss price then sell. If you prefer a tighter stop loss, say 15%, then multiply your peak price with 1-15% (85%), and so on.
Example of a spreadsheet with stop-loss price calculations for a portion of a portfolio. Click on figure to magnify. Column 1 is Name of stock; Column 2 is the stock symbol; Column 3 is current share price; Column 4 is either purchase price or most recent high whichever is higher; Column 5 is allowable maximum loss at which point sale is triggered; Column 6 is the corresponding stop-loss share price. Sell Flag triggered at maximum allowable loss from peak. Column 7 flags if current price exceeds last high. Update your sheet periodically, preferably once per week.
 
I like a stop-loss trigger around 25% - research suggests this is a good number. But in the end, it is up to you to decide how much pain you can handle before you want to pull the emergency brake! Above is a table with an example of a stop-loss spreadsheet that you may want to use.
 If you bought stocks of good companies that don’t go under, chances are that the crashed stock will eventually recover and flourish. So, if you can’t sell at your stop-loss price that is OK. You are only trying to build a war chest for when the market has bottomed and stocks are on sale – thus improving your future portfolio performance.  Try to sell your riskiest/shakiest stocks first as they have least chance to recover in subsequent months or years.
Don’t chase the market down because if you sell too low, you may never have a chance to recover (how can you if you no longer own the stock and have no money left to invest?). Once you have built a decent war chest, say you are 30 to 40% cash, you can sit back and wait for clear signs that the market is near a bottom. At or near the bottom you will get hints that the turn-around is not far away. It is not our intent to time the bottom precisely, we’ll be buying once prices are attractive enough and when we think that there is not a lot of down side risk. We’ll discuss some of this in more detail in the future.
Now, please, understand. I don’t think a bear market is imminent. To the contrary (see my outlook for 2014), but I want us to look ahead and be prepared once the next bear market starts.

No comments:

Post a Comment