The Difference between Dogs that Bark and Dogs that Bite

You have a portfolio full of stocks – some are doing well while others are struggling. What should you do about those "dogs?" If you could just turn those losers into winners, the returns of your portfolio would look a lot different. Should you sell now or hold on and hope they come back? No matter who you are, you're going to face this decision at some point. Before you hit the "sell" button, consider the following points. Sometimes the bark of a falling stock is worse than its bite.

Client: I have several stocks in my portfolio that are down – several of them are down significantly. Losing more than 20% in a stock makes me extremely nervous – should I sell these positions?

Advisor: No one likes to see a stock decline in value and it can be hard to hold on when your mind is screaming "Sell!"

However, selling a stock because it is down 20% (or any other number, for that matter) is what is commonly referred to as a basic stop loss strategy. By putting a "stop loss" on a position, you put a limit on how far fall the stock may fall before it is sold. Stop losses, which can be automated (i.e. the position is automatically/electronically sold when it reaches a certain price level) or manual, are designed to limit the downside in a position.

Client: That actually sounds pretty appealing.

Advisor: In theory, it does sound like an attractive strategy. In application, however, it's not the bargain that it appears to be. Over the past several years, there have been a number of scholarly journals that suggest that stop losses are an ineffective way to manage risk in an account. Stocks are not serially correlated, which essentially means that historical price movement has no bearing on future performance. In other words, just because a stock was down yesterday, last week or the last six months doesn't mean it will be down in the future. If that was not the case, we could simply always buy winners and avoid the losers. Of course, it doesn't work that way as history is filled with examples of stocks that were down 5, 10 or 50% only to quickly recover to new highs.

In some ways, stop losses also run counter to the idea of risk control. In my previous columns, I have written how important it is to build a counter-strategy into your portfolio. If you only purchase stocks that move in one direction, you have built a portfolio where each position is highly correlated to the other. If they move up, you're in good shape, but if they move down, you're in trouble.

There are a few other minor considerations. First, the use of stop losses can lead to additional transaction costs – especially if your "stop" is at a low level (e.g. 5%). Second, because stocks tend to move with the broader market, a declining market can force you to sell huge portions of your portfolio at once.

Client: I understand that past performance doesn't necessarily predict future returns, but if a company falls 20%, isn't that company just a dog? If it walks like a dog and it smells like a dog…

Advisor: …it might be a dog…or it might not. Again, just because it is barking doesn't mean it will bite.

Let's suppose that we set a stop loss of 20% on each position in your account. There are countless examples of stocks that have fallen 22% only to immediately gain 30%. So, in that case, maybe we set the level at 25%. Again, there are companies that have fallen 27% only to shoot up 60%. I think you see where I am going here. Stop losses are just arbitrary points where there are always exceptions. Statistical research actually has shown that there is no level of stop losses – down 10, 20, 30 or 50% - that leads to a superior portfolio return, specifically for an investor with a long time horizon.

Think about it another way. If you set a stop loss of 20%, doesn't that mean you must only buy stocks that are within 20% of their all-time highs. We know that doesn't make any sense, so why does a stop loss strategy? If one person buys a stock at $50 and another person buys it six months later at $100, what should they do if the stock drops to $80? Should they both sell it, or just the person who bought it at $100?

Client: OK, I see your point. So, what criteria should be used when deciding to sell or hold a stock?

Advisor: That's the million dollar question. Of course, every position is going to be different, but there are some guidelines that can help you to be a more disciplined investor.

First, any investment decision should be made based on forward-looking factors. Simply looking at yesterday's change in share price won't tell you anything about what is going to happen tomorrow. Second, think about the company's fundamentals. If you did a good analysis on the stock at the time you bought it and determined that it's a superior company in a growing industry with meaningful competitive advantages relative to its peers…has anything materially changed? Has an adverse event affected its core business strategy? Is the company losing market share? Is its management bad? If the answer to those questions is yes, then you may want to consider selling because the fundamentals of the company have changed. Also, think about the sector/country to which the stock belongs. If it is a domestic technology company, how do you think those types of companies will do in the next year? Will demand for their products be strong or weak?

Oftentimes, the share price may reflect the answers to these types of questions; in other cases, it may not. Either way, simply looking at price changes is, unfortunately, an easy way to turn your entire portfolio into a "dog."

The Advisor's Corner tackles a common situation or issue facing financial advisors and their clients.