The sword of inflation

July 11, 2022

The sword of inflation ‘slices’ cash and credit away from consumer spending. The latest rise of inflation rates, from 2% before 2021 to above 8% in 2022, reduces the purchasing power of money. Consider today’s dollar, which buys 25% less gasoline compared to one year ago. Relentless inflation causes families to either spend more income, withdraw more savings, or borrow money to pay higher costs of living.

Borrowers with good credit ratings are expected to repay loans with interest in a timely fashion. The Federal Reserve is currently increasing the difficulty of borrowing money [i.e., ‘tightening credit’] by raising the interest rates of loans. Corporations will eventually produce fewer goods and services in response to regulatory tightening of the credit needed to buy supplies and pay wages. Reduction of corporate productivity threatens stock returns and economic recession.

The rate of return from a stock investment, –or any other financial investment–, measures the face value [i.e., “nominal” value] of the investment’s profit; but the “real rate of return” measures the purchasing power of the profit. Inflation lowers the real rate of return, which reduces the purchasing power of a profit. The effect of a bear market on investment profit is bad enough; inflation adds an additional strain to profitability.

Copyright © 2022 Douglas R. Knight


2022 bear market, personal impact

July 4, 2022

One of the biggest risks of investing is that of encountering the inevitable “bear market” during a market cycle. Today’s stock market descended into a ‘bear market’ on June 13th, 2022, when the market index fell by 21% below its previous ‘high’.  My SmallTrades portfolio fell by 26% over the same time period [Fig. 1].  

Fig.1 bear market

Figure 1 shows a greater loss of market value in the portfolio, compared to its index, due to losses incurred by the portfolio’s holdings.  Here’s what happened:

In January, 2022, last year’s broad market ETF [ticker SCHX] and two stocks with disappointing share prices [tickers NVEC and NKLA] were replaced by a growth sector ETF [ticker SCHG] and three established stocks [tickers FB, MKSI, and SMED].  Residual cash was added to several stocks as needed to equalize the distribution of stock investments.  Consequently, the distribution of invested principal shifted from 80% ETF-20% stocks to 70% ETF-30% stocks in three months.  Figure 2 illustrates the sequential transfer of cash from the ETF to the stocks  [Fig. 2].  

Fig. 2 reallocation

Meanwhile, a market-wide decline in prices diminished the market value of my portfolio over the entire six-month period [Fig 3].  

Fig. 3 impact

All relative values started at 1.00 on December 31st and subsequently changed due to the combined effects of portfolio revision combined with the 6-month onset of the ‘bear market’.  Parallel declines of unit values in the stock market (black line), portfolio (red line), and ETF (green line) are consistent with a general downward trend of share prices driven by pessimistic trading in the stock market.  A transient surge of my stock values (blue line) reflects infusions of cash into several stock investments during the first 2 months of portfolio revision.

Delistings might add to losses during the ‘bear market’.  Suppose two of my stocks with the worst market performance were delisted on June 1st.  Estimated losses of -5.1% stock value and -1.6% portfolio value would deepen the June 13th losses described in figure 1.  The diversification of my stock investments protects from a steeper loss caused by any delistings. Hopefully my portfolio will remain intact in the near future and recover its growth trend after the “2022 bear market“.

Copyright © 2022 Douglas R. Knight 


2021

January 26, 2022

My private SmallTrades Portfolio is a Roth Account in which I no longer make annual contributions and cash withdrawals. Calendar year 2021 marked the 14th year of active portfolio management.  Figure 1 shows the latest portions of year-end market value as 81% index-ETF, 18% U.S. stocks, and 1% money market. 

Fig 1.

Annual returns

My investment goal is to earn an annual rate of return above that of the benchmark Standard & Poors 500 Stock Index.  Unfortunately, the Portfolio usually underperforms the Benchmark.  

Fig 2.

Figure 2 presents the history of annual returns for the Portfolio (blue bars), portfolio holdings (yellow & red bars) and Benchmark (black bars).  In year 14, the Portfolio earned a 27% rate of return compared to the Benchmark’s 29% rate of return, thus underperforming the Standard & Poors 500 Index by a margin of 2%. The history of annual returns reveals devastating losses of market value in the first 6 years followed by encouraging gains in the last 8 years.  Speculation and hurried trading, augmented by the 2008 Recession in year 1, created multi-year losses.  After year 6, reduced speculation and slower trading produced multi-year gains.

14-year growth

Devastating losses of Portfolio value in the first 6 years precluded any chance of matching the cumulative growth of the Benchmark over 14 years.

Fig. 3.

Figure 3 displays the cumulative growth of annual returns as a chain of “unit” market values.  The unit market values of the portfolio (blue dots) are ratios of year-end market value to the initial market value at time 0.  After 14 years, the Portfolio’s compound annual growth rate reached 4% compared to the Benchmark’s 11%.

8-year growth 

To evaluate the cumulative growth of annual returns in the last 8 years, I reset the unit value to $1.00 at the end of year 6 and recalculated the succeeding unit values now displayed in figure 4.  

Fig. 4.

Less speculation coupled with longer holding periods enabled Stocks (red dots) to outperform the Benchmark (black dots) through year 10 and generally outperform the Portfolio (blue dots).  The Portfolio (blue dots) matched the performance of its ETF (yellow dots).  

Summary

Measurements of annual return and cumulative growth show that the SmallTrades Portfolio continues to underperform its Benchmark by a wide margin of 7% cumulative growth over 14 years.  The last 8 years produced encouraging results based on improvements in portfolio management.  To continue improving, but not wishing to leverage my investments, my choices are to invest in a growth index ETF and/or re-allocate assets to a higher portion of growth stocks in the portfolio.    

Copyright © 2021 Douglas R. Knight


2020

January 18, 2021

The SmallTrades Portfolio holds cash, one exchange-traded fund (ETF), and a folder of stocks (figure 1).  

Figure 1.

Strategy

The SmallTrades investment goal is to earn an annual rate of return —as measured by percentage change of market value over the year— which surpasses the performance of the benchmark Standard & Poors 500 Stock Index.  In figure 1, one index-ETF creates 80% of the Portfolio’s market value with an expectation of matching the benchmark’s rate of return.  The stocks contribute 20% of the market value with an expectation of outperforming the benchmark’s rate of return.  

Performance

During 2020, the SmallTrades Portfolio earned an 18.2% rate of return compared to the Standard & Poors 500 Index’s 18.4% rate of return, thus matching the benchmark’s performance. In figure 2, the 12-year trend of performance was considerably better for the benchmark than the portfolio.  The benchmark’s 9.8% compound annual growth rate (CAGR) exceeds the portfolio’s 2.8% CAGR.  Portfolio mismanagement explains its underperformance. 

Figure 2. The unit value is a ratio of final-to-initial value. In this chart, the initial value was measured on 12/31/2007. Unit values less than 1.00 represent a loss and greater than 1.00 represent a gain.

In figure 3, the 7-year trend of performance was considerably better for the benchmark compared to the portfolio.  The ETF performance coincided with that of the portfolio, indicating that the ETF is the major determinant of portfolio performance.  

Figure 3. The unit value is a ratio of final-to-initial value. In this chart, the initial value was measured on 12/31/2013. Unit values less than 1.00 represent a loss and greater than 1.00 represent a gain.

Discussion

The “Great Recession” of 2007-08 devastated the Economy and the stock market as well as my portfolio.  The effect of the “Recession” is seen in figure 2.  The portfolio’s benchmark recovered higher and faster than it’s market value. 

The stock market declined in the last quarter of 2018, which caused corresponding declines in market value of the portfolio’s ETFs and stocks (figure 3).  That was a wakeup call to revise my investment strategy in 2019.  First, I replaced the 4-sector group of ETFs (discussed in AR2018) with the current large-cap ETF (SCHW in fig 1).  Second, I stopped using stop-loss orders to protect from losses and started using limit orders to capture large gains.  The stop-loss orders focused on minimizing losses in a volatile market rather than seeking long-term gains.  The result was a dramatic increase in performance of the portfolio, ETF, and stocks in 2019.  The stock market crash of March 2020 and the Pandemic of 2020 combined to level the stock performance during 2020.  I might have done better with different stocks, but that’s wishful thinking.  Fortunately, the performace of the ETF protected the growth of my portfolio.  My plan is to continue seeking long-term gains.

Copyright © 2021 Douglas R. Knight


Financial health

May 17, 2020

Long-term investors depend on their stocks to remain viable during economic recessions.  In today’s Coronavirus Pandemic, businesses of all sizes are losing income from the forced reduction of consumer spending, which may destabilize companies to the brink of bankruptcy.  Investors can assess stability by reviewing the financial health of their companies.

Financial health is the ability to pay all obligations in a timely matter.  Credit ratings and analyst reports use propriety methods to measure financial health.  You can independently rate the financial health of a public company using a single numerical score from 0 to 10 based on liquidity and solvency; the higher the score, the healthier the company (eq. 1).

equation 1:    Health = Liquidity + Solvency

Liquidity

Liquidity refers to the ease of converting current assets into cash for payments of current liabilities.  Current assets are considered convertible to cash within one year.  Some assets are more liquid than others. Savings accounts, checking balances, money market funds, and receivables [i.e., customers’ IOUs] represent liquid assets. Inventory [i.e., unused supplies and unsold products] is considered an illiquid asset.  Current liabilities are the costs of paying business expenses such as wages, payables, and interest on short-term credit.  The following ratios provide useful measurements of liquidity:

  • Current ratio = Current assets / Current liabilities.
  • Quick ratio = (Current assets – Inventory) / Current liabilities
  • Interest coverage = EBIT / Interest  [EBIT is the company’s earnings before accounting for the charges of interest and tax; EBIT is a measure of recurring income]

 

liquidity

chart 1

Solvency

Solvency refers to the liquidation value of a company in case the company must pay all of its short-term and long-term liabilities. I use the shareholders’ equity [aka net worth or book value] as a common denominator for the measurement of solvency.  Solvency ratios and free cash flow provide useful measurements:

  • Debt-to-Equity = Long-term debt / Shareholders’ equity.
  • Financial Leverage = Total assets / Shareholders’ equity.
  • Free Cash Flow = Operating cash flow – Capital expenses

 

solvency

chart 2

Examples

Chart 3 displays health scores for a list of companies identifiable by stock tickers; they are the current holdings of my investment club.  The data were calculated with the formula in eq. 1 using open source data for liquidity and solvency.  Three stocks received low health scores of 2.

health

chart 3

From chart 3, I selected five strong competitors of VZ and CMCSA to determine if the low health score represents a larger group of 7 competitors listed in the trading sector of Communication Services.  The additional competitors are listed below in chart 4. Three of the additional competitors matched the scores of CMCSA and VZ, inferring that most companies in that select group operate with low liquidity and solvency.

competitors

chart 4

Another comparison was made using a sample of stocks with an open-source, proprietary grade of low financial health (chart 5).  One stock, JCP, recently filed for chapter 11 bankruptcy.

others

 chart 5

Risk management

The health scores in chart 3 are based on historical data at least 3 months old.  Stocks with the lowest scores are considered more unstable.  If, in your informed opinion, there’s a credible risk of bankruptcy and delisting, you can protect your investment by either selling the stock or placing a stop-loss order on it.

Conclusion

Open-source financial data can be used to assess the risk of potential bankruptcy and delisting among publicly traded stocks, especially during an economic recession.  Combined assessments of liquidity (chart 1) and solvency (chart 2) additively form a health score of 0 to 10, with lower scores implying poor financial health.  The scoring system is easy to implement, but unreliably predicts financial failure of public companies with low scores.  Additional fundamental analysis of the company is strongly recommended and meanwhile, if you wish to protect your investment from a substantial loss, place a temporary stop-loss order on the holding.

Copyright © 2020 Douglas R. Knight 

 

 

 

 

 

 


2019

January 5, 2020

The SmallTrades Portfolio holds cash plus an exchange-traded fund (ETF) and a folder of stocks (figure 1).

SmallTrades Portfolio, 2019

Figure 1 displays 2019’s year-end composition of the SmallTrades Portfolio. COLUMN HEADINGS: “Ticker” is the trading symbol of the “Security” as listed in the U.S stock exchange.  “Mkt Cap” stands for ‘market capitalization’, which is the total market value for all tradable shares of a given security.  “Allocation” is the percentage market value of each holding relative to the market value of all holdings in the Portfolio.  “Strategy” is the investment strategy.  STRATEGY: “Passive” strategy relies on the ETF’s computers to track the value of a selected market index.  “Drip” signifies the automatic reinvestment of dividends earned from long term investments in ETFs and stocks.  “Growth” stocks are expected to earn long term capital gains.  “Swing” stocks are expected to earn short- or long term capital gains based on a pre-defined range of price growth.

Strategy

The investment goal of the Portfolio is to earn an annual rate-of-return that surpasses the performance of the benchmark Standard & Poors 500 Stock Index.  One index-ETF dominates the Portfolio’s return with an expectation of matching the benchmark’s rate of return.  A subordinate folder of selected stocks is expected to outperform the benchmark’s annual rate-of-return.

Performance

The Portfolio earned a 29.7% total rate-of-return during calendar year 2019.  Although the Standard & Poors 500 Index earned a higher rate of 31.5% in 2019, I’m pleased with the Portfolio’s performance for these reasons:

  1. 2019 was the first year that the Portfolio’s market value surpassed the initial market value at year-end 2007 (figure 2).  As reported in an earlier post, the market value declined in 2008 due to mismanagement, then took 12 years to recover by the process of employing trial-and-error strategies of management. The strategies gradually improved to the current idea of using an index-ETF to earn the benchmark return and supplementing that return with a subfolder of growth stocks.
  2. Converting 2018’s diversified ETF folder to 2019’s single ETF successfully raised the ETF folder’s market value by 33.9% in a single year (figure 3).
  3. Revising both the investment strategy and the composition of 2018’s stock folder raised its market value by 54.9% (figure 3).

 

2008-19 portfolios

Figure 2.

 

2014-19 stocks & ETFs

Figure 3.

Copyright © 2020 Douglas R. Knight

 

 

 

 

 

 


Model Portfolios, updated

January 23, 2019

Portfolio Visualizer is a highly rated online tool for designing investments (ref. 1). I used it to backtest the model portfolios listed in the following chart:

models

Legend: The top row shows the trading symbols of six index funds selected to build the model portfolios in rows 2-5.  The portfolios were backtested from December 2018 to January 2010.  $1.00 was initially invested in each portfolio and allowed to grow in value to the final balances shown in the righthand column.  The performance benchmark is Standard&Poors 500 TR Index in row 6.

Four-sector models in rows 2-4 represented diversified investments in stocks (VT, VTI), real estate investment trusts (VNQ), investment grade U.S. bonds (AGG), and gold bullion (GLD).  Several observations:

  • Four-sector models outperformed the bond market as determined by comparing their balances to the $1.32 that would result from investing only in AGG.
  • Portfolio performance was affected by the percentages of the index funds. The final balance of  four-sector models increased with the total percentage of stocks (VT, VTI) and real estate (VNQ) investments. 
  • Four-sector models underperformed the benchmark.

The one-sector model in row 5 held diversified investments in U.S. stocks. SCHX is a proxy for U.S. large-cap stocks and VTI is a proxy for all U.S. stocks. Among models, only the final balance of this model surpassed that of the benchmark in row 6.

Applications

Four-sector models are ideal portfolios for making short term investments of 1-5 year time periods. The goal of four-sector models is to improve safety by reducing the downside risk of investing in one sector.

The one-sector model of diversified U.S. stocks is ideal for making long term investments of 10 or more years.

Plan

Last year’s SmallTrades Portfolio, in 2018, was a four-sector portfolio that underperformed the benchmark.  In 2019, the new SmallTrades Portfolio will hold a group of actively managed stocks plus the passively managed Schwab U.S. Large-Cap ETF (SCHX). The initial allocation will be 20% stocks and 80% SCHX.

Thesis: SCHX is designed and tested to match the performance of the benchmark. Successful management of the stocks will raise the portfolio’s total performance above that of the benchmark.

References

  1. Vikram Chandrasekhar, 2016.  What is the best tool to backtest a portfolio online?

Math

The total return of a portfolio is estimated by the following formula:

RT = aRA + bRB+ cRC + dRD

For example, what is the estimated total return for the following portfolio?;  

25% VT + 25% VNQ + 25% AGG + 25% GLD

  • a, b, c, and d = 0.25.
  • RA = 7.19%, RB = 10.21%, RC = 3.13%, and RD = 1.37%.
  • RT = 0.25*7.19% + 0.25*10.21%+ 0.25*3.13% + 0.25*1.37% = 1.80% + 2.55% + 0.78% + 0.34% = 5.47%

By comparison, the Portfolio Visualizer  reported RT = 5.93% with a final balance of $1.68.  

Copyright © 2019 Douglas R. Knight 


2018

January 19, 2019
Once again, the SmallTrades Portfolio failed to outperform 
the Standards & Poor 500 TR Index ('benchmark'). In 2019, I
will replace five exchange-traded funds (ETFs) with a single ETF.

The SmallTrades Portfolio is actively managed within a tax-protected Roth IRA.  No cash has been added or removed from the account since the time of inception in 2007.  Figure 1 describes the portfolio and its investment strategy:

portfolio 2018 v3

Fig. 1. The holdings as of 12/31/2018.

The following strategies are used to earn capital gains:

  • The passive strategy is to collect dividends and capital gains from exchange-traded index funds (ETFs).  Each ETF is ‘passively’ managed to match the performance of a market index rather than ‘actively’ managed to outperform or underperform a market index.
  • The swing strategy is to buy the stock at a low price (‘bargain’) and sell it at a high price, however long the price-swing happens to occur.
  • The growth strategy is to purchase a reasonably priced stock and hold it until the company stops growing over several-to-many years.  The stock price should increase with the company’s profit.
  • The drip strategy is to buy a reasonably priced stock to collect dividends and reinvest them in additional shares of stock.  The beneficial effect of ‘drip’ increases as the stock survives several market cycles.

2018 Performance

Figure 2 shows the changes in value for every $1 invested in the Portfolio (solid blue line) and Benchmark (dashed blue line) after 12/31/2007.  The market value of the benchmark was consistently higher than that of the portfolio.

invested $ portfolio

Fig. 2.

 

In 2013, I replaced the Portfolio‘s mutual funds with ETFs that match the performance of 4 market sectors based on a model portfolio of global stocks, U.S. real estate investment trusts (REITs), U.S. bonds, and gold bullion.  I rebalanced the ETFs as needed and continued to actively manage a group of stocks.  Figure 3 shows annual fluctuations of the stock values (solid red line) and ETF values (dashed red line) as if $1 were invested in each group on 12/31/2013.

invested $ stocks

Fig. 3.

The benchmark (solid blue line) underperformed the stocks and outperformed the ETFs until 2018, when the benchmark surpassed both groups of investments (Fig. 3).

Why?

Several events in 2018 worked against the portfolio.

  • The U.S. stock market lost its collective annual earnings in the last quarter of 2018.  Most stocks declined in value.
  • Stop-loss trading orders triggered steep losses from 5 stocks in the portfolio.  Four were high-risk investments in small companies that failed to generate returns.  One investment was a large company with steadily declining earnings.
  • The 4-sector model portfolio predicted that the portfolio’s ETFs would collectively grow by nearly 9% every year, but instead they grew at half that rate, 4.4% annually.  The databases for the model portfolio were outdated (limited to the time period of 1997-2011) and have not been updated.

Plan

The new SmallTrades Portfolio will hold one index fund, the Schwab U.S. Large-Cap ETF (i.e., SCHX), and a group of stocks.  The SCHX is designed and tested to match the performance of the benchmark (more information in Model Portfolios, updated). The stocks will initially comprise 20% of the portfolio’s market value and they will be actively managed to outperform the SCHX.  Consequently, the portfolio’s growth should outperform the benchmark’s growth.

Copyright © 2019 Douglas R. Knight


2017

January 1, 2018

My SmallTrades Portfolio holds stocks and broad-market index ETFs (chart 1).

chart 1. SmallTrades Portfolio in 2017.

Chart 2 shows the diversification of ETFs as measured by percentages of year-end market values among ETF classes.

chart 2. Diversification of ETFs in 2017.

Chart 3 shows the diversification of stocks among 8 market sectors as measured by percentages of year-end market value for each stock sector and the ETFs.

Chart 3. Distribution of stocks and ETFs by market sectors.

Chart 4 shows the distribution of stocks according to market capitalization.

Chart 4. Combined market capitalizations.

Performance

My investment goal is to outperform the “Benchmark” Standard & Poors 500 Total Return Index, yet my portfolio has never outperformed the Benchmark (chart 5).

Chart 5. Portfolio performance.

Chart 5 shows growth trends for the benchmark (blue dashed line) and portfolio (solid blue line) since 2007 [the benchmark represents a passively managed, buy-and-hold investment; my portfolio is an actively managed investment].  On the Y axis, a unit value of $1.00 was assigned to both the total market value of the Portfolio and the Benchmark on December 31, 2007. Ratios of subsequent market- and benchmark values to the 2007 baseline are displayed line plots on the chart.

In 2014, my investment policy was modified to buy stocks of good companies and hold them for the long term. Chart 6 shows the result of my stock investments (red line) compared to the Benchmark Index (blue line) and ETF investments (red dashed line). The unit value of $1.00 was calculated on December 31, 2013. Since then, the stock group clearly outperformed the Benchmark and ETFs.

Chart 6. Stock and ETF performances.

Risk Management of ETFs

Broad-market index ETFs are primarily protected against stock losses by the passive management of investment portfolios which mimic the composition and performace of reputable market indices.

ETFs are secondarily protected by rebalancing significant allocation errors as described in the SmallTrades Portfolio’s strategies for risk management. In theory, a significant drift of asset classes occurs when one asset class surpasses a 24-28% allocation error. My preferred allocation of ETF market values is 30% stocks, 30% REITs, 20% bonds, and 20% gold bullion.

A perfect allocation of ETFs would result in 0% allocation error.  Furthermore, allocation errors would reflect disproportional gains or losses of market value.  Chart 7 shows the year-end allocation errors (blue bars) and error limits (red dashed lines) of my ETFs. There was growth of the Global Stocks ETF and decline of the remaining ETFs. Any allocation error that exceeds an error limit (red dashed line) should trigger trades that rebalance the ETFs to the preferred allocation.  My ETFs were not rebalanced in 2017.

Chart 7. ETF allocation errors in 2017.

Risk management of Stocks

My stocks are primarily protected against risks of steep loss by diversification of the market sectors, as illustrated in the preceding chart 3. The second line of defense is stop-loss orders.  In keeping with the investment goal of holding good stocks for the long run, I set ‘stops’ at a wide margin to prevent recent market fluctuations from triggering an unwanted sale.

Plan

The SmallTades Portfolio will continue to be actively managed for long term success. The ETFs will be rebalanced anytime there’s a 24% allocation error or a modification of the ETF holdings. In 2017, I failed to sell large cap stocks in order to buy good small cap and mid cap stocks. Consequently, 60% of the total market capitalization of my stock portfolio was in the Large Cap category.  In 2018, I would like to reduce the Large Cap category to 40% total market capitalization and boost the market capitalization of small- and mid cap stocks issued by good companies with potential growth of earnings.

Portfolio history

  1. On 12/31/2007, the portfolio held a group of actively managed mutual funds in a tax-deferred Roth account. Since then there have been no cash deposits or withdrawals and the portfolio still resides in a Roth account.
  2. During 2007-2010 the actively managed mutual funds were traded for stocks in an attempt to earn a 30% annual return by process of turning over short term ‘winners’.  Four mistakes led to a big loss:
  3. mistake #1: after a couple of short term capital gains from Lehman Brothers Inc., I ignored the dangers of the company’s large debt and lost $45,000 during Lehman’s decline to bankruptcy.
  4. mistake #2: substantial long term profits from good companies were lost by selling holdings for short term profits. My strategy was to earn a quick 30% in the first year and re-invest in the next winners. It was too difficult to identify the next winners.
  5. mistake #3: day-trading was a game of chance that I played and managed to break even; meanwhile, good stocks grew in value.
  6. mistake #4: a trial of investing in leveraged ETFs resulted in losses due to negative compounding.
  7. I abandoned the goal of a 30% annual return in 2012 by adopting a more realistic, but still aggressive, goal of outperforming the benchmark. That same year, I changed my investment strategy to that of holding a mixed portfolio of 80% broad-market index ETFs and 20% stocks for the long term. ‘Good’ companies attract and retain investors for many years. I will search for profitable companies with growth potential that are undervalued by the stock market. My search methods include reading reputable sources of business news, partiicipating in an investment club, using stock screeners, and attending investor conferences. Then I include and exclude stocks by reading analyst reports, financial statments, SEC filings, and market analyses. Valuation critieria help me decide if the stock price is worth paying.
  8. Prior to March, 2016, five ETFs were allocated to four asset classes with each asset class holding 25% of the combined market value. Since my retirement income didn’t depend on making withdrawals from the SmallTrades Portfolio, I increased my ETF exposures to global stocks and REITs by decreasing my exposures to investment-grade bonds and gold bullion. The new allocation rule was 30% stocks, 30% REITs, 20% bonds, and 20% gold. Any drift in allocation to a 24% error will be rebalanced.

Stop losing value from a declining price

March 4, 2017

background

The market value of your stock equals your principal (i.e., the amount you invested) plus any profit or loss from price fluctuation. The market price that moves below what you paid to purchase the stock will produce a loss of principal if you sell the investment. Here are several risk factors that may drive stock prices downward:

  1. Company performance. ‘Good’ companies attract investors. Conversely, ‘distressed’ companies repel investors.
  2. Industry performance. Business cycles can affect the sales of products from an entire industry. For example, sales of new automobiles declined during the Recession of 2008.
  3. Market cycles. Aside from business performance, the entire stock market is subject to periods of declining prices due to massive selloffs by investors.

The risk of an extreme loss can be prevented by setting a stop-loss price (“stop”) to sell part or all of your shares.

ways of setting the stop

The systematic way is quite simple. If the market value is below your invested principal, then select an absolute loss or a fraction of the principal. Examples:

  1. Absolute loss. Suppose you invest $5,000 in 100 shares of stock (i.e., $50/share) and you can tolerate a loss of $1,000 should the price start to fall. Regardless of future prices, you choose to stop the decline at $1,000 below the original $5,000 value. In this example, the stop would be $40/share [stop = (value – loss)/shares = ($5,000 – $1,000)/100].
  2. Fraction of value. Suppose you can tolerate a 10% loss from an investment originally valued at $5,000 for 100 shares.  Ten percent is one-tenth of 100, which is equivalent to a decimal number of 0.10. The stop would be $45/share [stop = (1.00 – decimal)*value/shares = (1.00 – 0.10)*$5,000/100].

The technical way is based on the stock’s historical prices. If you want to minimize the chance of a sale, set the stop at the lowest price from the past 5-10 years. Beware that setting the stop at a historical low may incur a steep loss. Other ways involve the more complicated analyses of trendlines, moving-average lines, or price statistics.

Another way is to adjust the price gap (gap = market price – stop) to the growth of capital gains. As the market price increases over time, choose a narrow gap to protect the capital gain or a wide gap to reduce the chance of a trade. Generally speaking, widening the price gap will reduce the chance of a trade at the risk of incurring a bigger loss.

add a limit price (“limit”) for extra protection

A brokerage firm will enforce your stop order for 30-90 days depending on the firm’s trading platform. The firm’s computer activates the order when the latest market price reaches the stop. The order is then filled at the next available price. In a chaotic market, the price could plunge below your stop to an exceptionally low value at the next available trade, resulting in a bigger loss than you planned. You might be able to prevent this result by setting a limit slightly below the stop. The trading order would be filled somewhere within the stop-limit price zone unless the transaction is cancelled, unfilled, when the next available price dips below the limit. The limit helps protect the extent of your loss.

who should worry about an extreme loss?

Nobody’s immune, but long-time investors have the least concern. Investment strategies such as dollar-cost-averaging and automatic-dividend-reinvestment plans will help protect against damages from periodic bear markets. Short- and intermediate-time investors are at greater risk for incurring an extreme loss from market down-cycles. For example, families who are saving to pay college fees or to buy a home risk big losses from a bear market.

conclusion

Stop orders are used to set the price for buying or selling exchange-traded products such as stocks, ETFs, and REITs. This article discussed the use of a stop-limit order to sell a stock in a declining market. Brokerage firms may restrict the duration of stop-limit orders to 30-90 days after which the order is cancelled without a transaction until you renew the order. Periodic renewals allow you to reconsider your strategy in light of the prevailing price trend. In a downtrend, simply renew the order. In an uptrend, you may wish to protect a growing profit by resetting the stop-limit order to higher prices. Click on this link to skimming a profit for another perspective on protecting a growing profit.

Copyright © 2017 Douglas R. Knight


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