Using Stop Loss in Investing

Should you have a stop loss if you are an investor? That is the question I have have been trying to answer for myself. I have been dabbling with various quant systems and obviously stop losses is a part of the thought process in any trading system.

Stop loss is a simple yet extremely powerful concept. It can protect you from major catastrophes that can completely erode your portfolio to protect a large part of gains made (when used as protective stops). It is part of the "money management" or "allocation" strategy followed in trading systems.

Money management is perhaps one of the most important things that I learnt while studying quant systems. And I find that not knowing it was stupid. Every investor MUST know about money management and adapt it to their own investing style. More on money management later.

There are only 2 types of stocks - trending and mean-reverting. 

Trending stocks are those that follow a trend (it keeps going up or down over time - since we are usually all long-only investors I will talk about price rise trends). The rising price trend is usually but not necessarily improving fundamentals like earnings. Examples are many like Pidilite, Asian Paints, HDFC Bank etc.

Mean reverting stocks are those where the prices keep oscillating about a mean position (which also tends to slant upwards but at a much lower slope). Practically, most stocks belong to this category. 

Stop loss should be used differently for the 2 types of stock. 

If you have bought a trending stock, a stop loss is a must. It helps in preventing massive losses in case your thesis is wrong or there is a major market correction. It also prevents in locking in gains by the use of a trailing stop loss. (A trailing stop loss is one where you keep raising the stop price as the price of the stock keeps going up). If you have bought a trending stock at 100, and it falls to 80, the trend is possibly broken and you need to reevaluate your thesis and hence get out of the position. Exactly, the same situation with a trailing stop. It gets hit when the trend reverses.

On the other hand, if you have bought a mean-reversion stock, where you are expecting a change in fortune, then a stop loss initially is a STUPID idea. This is precisely why Warren Buffett or any other value investor do not use stop losses. Value investing, by definition, is a mean-reversion strategy, where you are expecting the price of the stock to revert back to its mean "value". In a mean-reverting stock, let's say you have bought it at 100 and expect it to revert to its intrinsic value of 150 in some time period. Now if the price falls to 80, ideally your philosophy should drive you to buy more at the lower price since you are now getting a better bargain and potentially more profits when the stock does mean revert.

How to set stops?

There are many ways stops can be put. Unfortunately, there is no correct way. Different people use different methods based on their trading style, capital at risk, investment horizon etc. Some basic strategies are:
1) Using a fixed percentage stop loss (say 10% or 20% from buy price)
2) Based on technical chart patterns (support levels, breakout levels, gaps etc)
3) Based on statistical indicators (Fibonacci levels, moving averages, ATR etc)
4) Volatility based
5) PE based (exit at x PE)
6) Growth level based (if earnings growth falls below x% for 2 quarters in a row)
7) So on and so forth...

Stop levels need to be in line with your capital and time horizon. If you keep a 5% stop loss and your a long term investor, you will get stopped out 99% of the time. You need to understand the volatility of the particular stock and make sure you do not get stopped out under normal market gyrations. However, if you are a day trader and are trying to make 1% return from the stock, even a 1% stop loss may be way too high.

Portfolio level stop loss vs individual stock stop loss

The next problem is whether to have an individual stop loss for a stock or a stop at the portfolio level. Again, like in nearly everything in life, the answer is "it depends". Individual stop loss, in my opinion, should be more liberal, if you are a long term investor. Something like 30-40% or even 50%. But if you combine it with a market level stop loss, then it could get triggered at a lower combined level. 
For example, say you have bought a stock at 100 and you have a 30% stop loss on it. You expect the stock to double in the next 4-5 years. When you bought it, the Nifty was at 11,000. Now, the markets start tanking and Nifty falls to 8800, which is a 20% loss on the index. Now, if you have a complex stop loss which takes both individual stock price and the index price, then you could actually be stopped out of the position even without the individual stock not having lost 30%.

Single or Graded Stops

You can use either single stop loss to get out of your entire position or graded stop loss to get out gradually. Example: Sell 50% at a 20% stop, and then 10% every 5% fall.  

Does a stop loss reduce drawdowns or lock-in losses? What is the impact on profits?

This is the most crucial question that very few people actually ask. I have been dabbling with this for a while now. **Stop loss in my studies, nearly always, reduces returns.** Obviously, there are many assumptions that have gone in the data studying primary amongst which is that you are not a very poor stock picker and you make reasonable profits when the markets are doing well. If you are not sure if you are a good stock picker, then use a stop. It is like a helmet. It will save your life if you crash.
However, if you are a good stock picker and have a good track record, 9 / 10 times your stop will get hit and the stock will recover ground post that. Only in very very rare cases like a DHFL or a Yes Bank would it protect you immensely. But then again, if you were a good stock picker you would have gotten out of those even without a stop loss. 

Is a stop loss strategy a behavioural strategy more than a money management strategy?
A stop loss is mostly a behavioural strategy. It is also a strategy for those who do not know the stocks they are buying so in a way it is ignorance insurance. It protects you from the unknown and from making stupid catastrophic mistakes. 

BOTTOM LINE: Since the world is dynamic and you can never know everything about everything, having an exit strategy is important for all your investments.  Stop losses are part of that exit strategy.