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.

Annual Performance Review - Intelsense Model Portfolio

We completed 1 year as an advisory on 31-Mar-2020. What a year it has been. Something we are unlikely to forget in our lifetimes. I am sitting at home as part of the unprecedented countrywide lockdown and writing this note.

First the performance.

Model Portfolio	-12.1%
Nifty	-26.3%
Nifty 500	-27.9%

The report and some thoughts are available here.

Stay indoors. Stay safe.

Weekend Reading

I am tired of Coronavirus related topics. So, completely avoiding them.

Forecasting and the stories we tell ourselves

Ample research shows that most experts do not make great forecasts. This might appear to be a problem if you are in the business of making predictions. But it turns out that the ability to explain what happened after the fact, often in a way that flatters your faulty prediction, is an incredibly effective coping mechanism. Barbara Mellers, a professor of psychology at the University of Pennsylvania, says, “We find prediction really hard, but we find explanation fairly easy.” We tell stories to ourselves and others to paper over our poor predictions.

https://www.morganstanley.com/im/publication/insights/articles/bin-there-done-that_us.pdf

The story of Hidesign

For a long time, Dilip Kapur thought international affairs was his calling. He moved from Pondicherry (now Puducherry), to the US to do a PhD in international affairs. But life had other things in store for him. While doing a part-time job at a leather factory, Dilip fell in love with leather. After completing his studies and returning to Puducherry, Dilip started making leather bags as a hobby. His time at the factory taught him all he needed to know about making leather bags. Dilip started sourcing leather from Chennai and started making hand-crafted leather bags in Auroville.

By 1988, Hidesign had ventured into garments, with leather jackets and long pants. The UK market couldn’t get enough of Dilip’s leather bags. Hidesign was soon present across 700 stores in London.

Dilip’s company now clocks Rs 170 crore gross annual revenue and has 1,400 employees. It has evolved from a leather goods maker into a lifestyle brand with presence in exclusive stores, airport stores, shop-in-shops, multi-brand outlets, and ecommerce platforms. It claims presence in 102 exclusive brand outlets and 112 large format departmental stores. Hidesign’s product portfolio comprises ladies’ bags, men’s bags, wallets, belts, shoes, sunglasses, luggage, and jackets. The ladies’ bags and men’s bags are its top sellers.

https://yourstory.com/smbstory/hidesign-leather-bags-brand-puducherry-business

Reading fiction is more important than nonfiction

When it comes to reading, we may be assuming that reading for knowledge is the best reason to pick up a book. Research, however, suggests that reading fiction may provide far more important benefits than nonfiction. For example, reading fiction predicts increased social acuity and a sharper ability to comprehend other people’s motivations. Reading nonfiction might certainly be valuable for collecting knowledge, it does little to develop EQ, a far more elusive goal.

One reason fiction works so well in the workplace is that characters, plots, and settings in foreign locales help anchor difficult discussions. The narrative allows participants to work through sensitive and nuanced issues in an open and honest manner. Also, research suggests that reading literary fiction is an effective way to enhance the brain’s ability to keep an open mind while processing information, a necessary skill for effective decision-making.

Research on reading shows literature study to be one of the best methods for building empathy critical thinking, and creativity.

https://hbr.org/2020/03/the-case-for-reading-fiction

Industry matters more than the business

What if Federer played badminton? He would face Lin Dan, the champion in that sport. Each man may be the best ever in his respective game, and both are extremely marketable, with competitive instincts and personal charm. But Dan doesn’t make anywhere near what Federer does—and he never will. That’s because Dan has an “industry” disadvantage. A Top 10 tennis player makes 10 to 20 times what a Top 10 player in any other racket sport earns.

Likewise, a company’s choice of industry matters a great deal—more than many realize. When we tracked the economic profit of the world’s 2,393 largest companies over 10 years, we found that about 50% of a firm’s performance compared to the broader corporate universe is driven by what’s happening in its industry, highlighting that “where to play” is perhaps the most critical choice in strategy. Your industry trend is the single biggest factor shaping your odds of outperformance.

https://www.mckinsey.com/business-functions/strategy-and-corporate-finance/our-insights/the-strategy-and-corporate-finance-blog/could-roger-federer-be-as-successful-playing-badminton

How meditation changes the brain

MRI scans show that after an eight-week course of mindfulness practice, the brain’s “fight or flight” center, the amygdala, appears to shrink. This primal region of the brain, associated with fear and emotion, is involved in the initiation of the body’s response to stress.

As the amygdala shrinks, the pre-frontal cortex – associated with higher order brain functions such as awareness, concentration and decision-making – becomes thicker.

The “functional connectivity” between these regions – i.e. how often they are activated together – also changes. The connection between the amygdala and the rest of the brain gets weaker, while the connections between areas associated with attention and concentration get stronger.

https://blogs.scientificamerican.com/guest-blog/what-does-mindfulness-meditation-do-to-your-brain/

Weekend Reading

I am personally tired of reading, watching and listening about the Coronavirus. So, this week there is nothing related to it or to its impact on the economy or anything like that. Stay indoors. Staf safe. We shall overcome.


Deep thinking works
Put bluntly, facts don’t exist. Versions of them do. Even if we could agree on facts, different versions of facts exist for each individual. And that’s a big reason many of us like to simplify this disparate view into numbers/financial statements, albeit losing perspective and nuance. In the world of big data, robots may arbitrage headlines, but they can’t (at least yet) ponder multiple subjective arguments like we can do. Counterintuitively, stretching investment horizons simplifies our job is in spite of additional possible outcomes. At least we are an order of magnitude right instead of precisely wrong.
https://www.valuewalk.com/2017/09/deep-research-vs-deep-pondering/


Jay Leno always saved money from his second income
From the moment he entered the working world, “I always had two incomes. I’d bank one and I’d spend one.” Leno continued relying on this strategy even after he started hosting “The Tonight Show” in 1992, even though he reportedly earned as much as $30 million a year at the height of his career.
“When I got ‘The Tonight Show,’ I always made sure I did 150 [comedy show] gigs a year so I never had to touch the principal,” Leno says. “I’ve never touched a dime of my ‘Tonight Show’ money. Ever.”
https://www.cnbc.com/2016/12/14/why-jay-leno-has-never-touched-a-dime-of-his-tonight-show-money.html


The story of friendship amidst competitors
When one industry stalwart, B.K.Birla, invites two his biggest competitors in the tea industry, B.M Khaitan and G.P.Goenka, to the board and they stay on for 33 & 43 years!
There is nothing unusual in founder shareholders inviting other businessmen to join a company’s board to expand management bandwidth, but what Birla did was unique: he invited two key industrialists from Kolkata who were invested in the same business to join his company’s board.
http://www.livemint.com/Companies/Q8XhCQE7JK4F92GjiwgkTO/BM-Khaitan-GP-Goenka-exit-ends-Jay-Shree-Teas-unique-e.html


10,000 Experiments Beat 10,000 Hours of practice
Following the 10,000-experiment rule means starting your day with not just a to-do list but a “to-test” list like Leonardo Da Vinci. According to Walter Isaacson, one of Da Vinci’s biographers, “Every morning his life hack was: make a list of what he wants to know. Why do people yawn? What does the tongue of a woodpecker look like?”
As you go through your day, following the 10,000-experiment rule means constantly looking for opportunities to collect data rather than just doing what you need to do. It means adding a deliberate reflection process based on reviewing data before the day ends.
https://medium.com/accelerated-intelligence/forget-about-the-10-000-hour-rule-7b7a39343523


Taking a break makes you stronger. Ask Federer.
Just three weeks before his 36th birthday, Roger Federer won his eighth Wimbledon and 19th career Grand Slam. Among all his other remarkable achievements, the two Grand Slams he has won in 2017 stands out – not because it proves how ridiculously talented he is but simply because they have come against the run of play. For a while now, sportsmen have been walking away from the sport they so obsessively love, taking a break and coming back even stronger.
https://amp.scroll.in/article/844329/the-most-important-lesson-roger-federers-wimbledon-win-has-taught-us-has-nothing-to-do-with-tennis

The Corona, Credit & Crude Conundrum

I shared this with Intelsense advisory members earlier.

You can download the document from https://intelsense.in/Saved/200322103826658_The_C3_Effect.pdf

or view it on Scribd (needs you to be logged in)

The C3 Effect by abhishekbasumallick on Scribd

The Index Fund Bubble

The global order for investment management firms has changed in the last 5 years. Index investing now more or less accounts for 20-40% of the global capital deployed whether through index funds, ETFs or index-hugging funds. Since an index does not have a cash allocation, there is no buffer when it starts going down. While going up, it feeds into the frenzy and the index constituents get more than their fair share of capital flows. And no one complains. When the tide reverses, the exact opposite happens. Stocks fall because they have fallen a lot. A virtuous cycle turns into a vicious cycle.

This is what we are seeing now. 

The way it possibly ends is when other investors (discretionary/quant/alpha-oriented funds) decide that some factor they are tracking (could be valuations, could be any other metric like volatility, global macro, relative strength, overbought/oversold indicators etc) is now in their comfort zone and start buying. The other possibility is that large investors will get scared of the fall in the indices and full out money thereby starving the passive funds of their fuel.

This is a reason why we are seeing such increased volatility in the global markets.

From a fundamental perspective, earnings are going to be severely hit, supply chains dented (maybe permanently for some, which I have discussed in my previous post). People still are trying to assess how bad things are going to be. 

One thing I am sure. We will now be extrapolating our fears.

No one said investing was easy. Equity gets a risk premium over other asset classes. Yes. A risk premium. Because it is risky!! 

To end let me quote, my friend and fellow VP member @zygo23554:

This virus is God's wrath that brings to the fore fragilities and frailties in your health, relationships and portfolios. 

Fear yourself, not the virus. All it does is show you the mirror so you realize who you truly are. 

What is changing in the business world with the coronavirus?

Just wanted to note down some thoughts on the possible impacts of the current Coronavirus pandemic and the resultant global market crash. I am not an economist, neither a political analyst but merely an observer of human and system behaviour.

Supply chain optimisation likely to incorporate redundancy and failover

The current global supply chain is optimised based on cost and time. That is manufacturers tend to get their components or parts built in places where it is cheapest t produce and ships it to the factories just-in-time. With a large-scale pandemic like situation, which comes right on the heels of US-China trade war, large (and small) corporates will rethink their supply chain and dependency on China. They will now need to build in inventory costs as the supply chain would need to factor in redundancy and supply disruption constraints. This will, in turn, increase the cost structures and reduce margins. Some industries, like electronics, which ran of wafer-thin margins, may find it very difficult to survive or will need to take price hikes.

Move from globalisation to localisation may get accelerated

The last few decades had seen an unprecedented wave of globalisation with free movement of people and products. This is increasingly facing headwinds as resistance builds up in local communities leading to economic and social strife. The rise of the right-wing globally and Brexit are manifestations of these social shifts. As more business shifts inwards, global companies will need to have a better local presence in countries they wish to do business in. Second-order impacts may include a decline of tax havens and higher taxes for global companies as they would need to pay taxes for profits in each individual country they operate out of.

New work culture building up

Working from home was prevalent in only a few industries like IT. With a lot more people getting used to working from home, it is likely that more companies will realise that they can actually run their businesses when employees do not come to one centralised office. This is a very profitable move for companies as they would be able to reduce expensive office space, maintenance, electricity and other such costs. Second-order consequences are too many to list here but a few prominent ones are negative sales impact on auto, petroleum, real estate prices. Shorter-term it would also have a negative impact on all crowded places like restaurants, shopping malls, movie theatres.

Ecommerce likely to get a boost

Online sales have already started getting bigger and is likely to expand much further once more and more people hesitate to go out in public places like crowded shops and malls.

Government & Central Banks have limited options

Respective governments and central banks essentially have two policy actions that they can use – fiscal and monetary. That is, they can tinker with taxes, government expenditure and interest rates. The issue is you cannot fix a supply-side issue with a demand-side solution. That is, if you are running say an automobile factory and don’t have the necessary supply of engines from China, then reducing interest rates will not solve your problem. This is the same reason why when food inflation shoots up, you can’t really do much by cutting rates, simply because the food is just not there. Similarly, neither does cutting taxes, both corporate and individual, help in any way. What these measures do is to price the risk in the market. With reduced interest rates, central banks (and governments) push the people to invest in riskier assets or fuel consumption or both. The last option that the government has is spending out of this problem. Government expenditure has the potential to create employment, provide a sense of security to corporates and basically spur the economic engine to start working once again, with the hope that it leads to a positive spiral of higher consumption and sustained growth coming back.

The Indian government gets a Godsend as crude prices collapse

India, as a major crude importer has just received a Godsend with crude oil prices collapsing due to the fight between Russia and OPEC (Saudi). The government finances are in a mess with no money to spend at all. With this fall in crude, the government can potentially use the money saved and channelize into infrastructure development. There are large areas where India can and should invest in for future global competitive advantage. Now is the time to get into those areas like green energy, increasing healthcare facilities, schools, colleges, railways, airports, inland waterways, ports, defence. The list can go on.

China is in a precarious situation

China is a very insulated country. But rumours are that the banking system in China is under stress and the coronavirus has only exacerbated the situation. Unless it can demonstrate that it has been able to successfully contain the outbreak and are getting back to normalcy, they will be the biggest sufferers as the global manufacturing supply chain will readjust and leave them behind. This will have a large long term impact on the social and political situation in China. But with an authoritarian government in place, it is likely that China will be able to show the resolve required to quickly get back to normal.

First global crisis in the age of social media and fake news

This is perhaps the first major global crisis in the age of social media. Social media amplifies and distorts messages, so the impact of people is very different from when all media was state-controlled or influenced.

Flight of capital to safety

There is a flight of capital towards safety and security. Unfortunately, in India, last 2 years has seen multiple critical situations in the banking and financial sector, one of which is currently underway. This has severely eroded the faith that investors have in banks. With a possibility of further rate cuts from RBI, bank deposits will become more unattractive. IN such a scenario, gold and US dollar tends to do well.

Investment horizon reduces during crashes

Market crashes have a way of reducing our time horizon from decades or years to weeks and days. If an investor just sticks to thinking about the underlying businesses and how they can get impacted by the change in the context, and maintain the long-term horizon, it will perhaps help in reducing the stress and anxiety.

Better to stick to your investment plan

All crises finally come to an end. This too shall pass. And when there is a global crisis, governments tend to take coordinated action. I would be very surprised if we do not see significant quantitative easing (reduced interest rates) and other policy measures announced by governments across the world.

So, fasten your seat belts and enjoy the ride. After a few years, you will probably tell the next generation of market participants, “Heck! I lived through that!”