Long-term investors should set stop-losses too

“Cut your losses short and let your winners run” is one of the cardinal rules of stock market trading. But this is a rule that long-term investors could benefit from following too.

One of my aunts was recently widowed and had inherited a portfolio of stocks from her husband. She was quite pleasantly surprised by the demat holding statement which ran into half a dozen pages and listed out over a 150 stocks valued at over ₹30 lakh. She sought help on whittling down the portfolio to a more manageable size. She was hopeful that by retaining 25 quality names and selling the remaining 125 stocks, she could raise a lot of cash to help her meet a down payment on her home.

But sifting through this portfolio gave us a nasty jolt.

Just 30 of those stocks accounted for ₹25 lakh of the portfolio value. The remaining 120 stocks would fetch just ₹5 lakh, as many of them had either stopped trading or had been decimated to penny status. It is not as if my uncle had been un-savvy with his stock market bets. There were a dozen or so multi-baggers in that portfolio which any professional investor would have loved to own. Stocks such as Ajanta Pharma, Eicher Motors, Amara Raja Batteries and Gruh Finance, bought in 2006, were up by 30 to 60 times till date.

But the real problem with the portfolio was its extremely long ‘tail’. For every single multi-bagger in the portfolio, there were as many as four other stocks deeply in the red. JP Associates, Unitech, Suzlon Energy, Punj Lloyd, GVK Power, Amtek Auto and Indian Overseas Bank had lost anywhere between 70 and 99 per cent of their original value over a ten-year period. Effectively, the large number of value-destroyers were eating into hard-won gains from the multi-baggers.

My uncle’s portfolio suffered from neglect because he couldn’t actively track it in his final years. But even fairly active investors are prone to the same mistake.

When one of our stock holdings begins to fall below its purchase price, our immediate instinct is to hold on to the belief that the market is wrong, and we are right. Yes, ‘market sentiment’ may trigger a 15 or 20 per cent correction in a stock, but it is essential to sit up and take notice when a stock falls 30 per cent or 40 per cent from your buy price. But behavioural finance tells us that this is moment when most of us develop ostrich-like tendencies.

Despite suspecting that our original investment was flawed, we simply hang on, hoping to recoup our buy price, so that we can ‘erase’ the mistake. Or we put the stock into cold storage, hoping that the next bull market will find buyers for it.

Usually neither strategy works. And that is how we end up with a portfolio that is full of wealth-destroyers.

Some investors compound this mistake by booking profits too early on their winning stocks too. After buying a business because its long-term prospects looked good, they get tempted by a 50 or a 100 per cent gain in a single year, to exit the stock.

But being in a hurry to take money off the table carries three risks. We may miss out on the real wealth creation potential of the business over the long term. We may redeploy that money in a dud and end up losing it. Or we may even keep waiting to re-enter it at a lower price, which never arrives!

It is this tendency to cut profits short and let losses run (the exact opposite of savvy trading behaviour) that leaves many investors with an equity portfolio resembling my aunt’s. There are a handful of multi-baggers dwarfed by a long tail of duds.

Now that we know the impact that such investing behaviour can have on our long-term wealth, lets see what we can do to avoid it.

One, when acquiring any new stock for your portfolio, use an online portfolio tracker service to capture your buy price and subsequent returns. Make a physical record of the prevailing earnings per share (EPS) and price-earnings multiple for the stock at the time of purchase, backed by a short investment argument.

Two, set up routine portfolio reviews once in six months, to monitor if the EPS is on track. A wide deviation should be your cue for a more detailed analysis. Also set up investment alerts on all your key companies so that you are aware of a sudden deterioration in the fundamentals or events that can affect stock prices. When governance or accounting issues hit a business, a stock can lose enormous value even over a week or a month.

Three, if you notice, during your review, that any stock in your portfolio has dropped by 30 per cent from your buy price, think seriously about selling it. This may seem counter-intuitive to fundamental investing (shouldn’t you be averaging it?). But if a stock is cheaper by 30 per cent, it is often a good sign that something was wrong with your investment case in the first place. Re-assess with an open mind. Would you buy the stock today, knowing what you do? If the answer is a no, sell it.

Four, resist the temptation to book profits on your winners based on absolute returns. Instead, take stock of the EPS growth and PE multiple of your winning picks. If the company’s stock has galloped because its earnings have beaten your wildest expectations, that should be reason to buy more of it and not to ‘book profits’ in haste!