Why is stop loss necessary?
It needs 25% gain to recover 20% loss, it needs 100% gain to recover 50% loss, and it need a whopping 400% gain to recover 80% loss.
- Dow Jones 30 index was down more than 80% from 1930 to 1932, and it took 23 years to recover.
- Japan NIKKEI 225 index was at 38,713 on Jan 4, 1990. After 18 years, NIKKEI 225 index was at 14,691 on Jan 4, 2008. It still needs to go up 163.5% to recover to its previous high.
- S&P 500 index was down more than 50% from 2000 to 2002, and it took 5 years to recover the loss.
- China Shanghai Composite Index fell a catastrophic 67% in less a year since October 2007.
Many literatures advise individuals to stay in the equity markets during the down trend, and some even suggest to invest more money by so-called “dollar cost averaging” method. These literatures in general claim if one misses the best X amount of days in the market during the research period, it would underperform the market by Y amount in the same period. However, these literatures usually do not mention:
- If one misses the worst X amount of days in the market during the research period, it would outperform the market by Z amount.
- Usually the best days are followed by the worst days, and the recovery is usually less than what is lost.
- The emotional toll (depth of drawdown) places on individuals due to continuous loss.
- The time required to recover the loss, especially if one is near retirement age. In theory, market will eventually come back to its previous high in the future, but an individual has only 20 to 30 years to accumulate retirement asset.
- Even during a bear equity market, there are many other alternatives to grow the investment, such as CD.
Stop loss is to take a break to prevent disaster and re-evaluate the investment system if necessary. It is designed to preserve capital, not to outperform the market.
There are many books and papers on how to stop loss and re-enter the market, e.g., William J. O’Neil’s book.
In the following a simple stop loss method is illustrated using S&P500 index, and it is intended to limit the drawdown, not intended to outperform S&P 500. One should back test this method before applying it on any financial instrument, such as a mutual fund in a 401k account.
A very common stop loss level is 7%, and one can re-enter when MACD crosses over from below. Following is an annotated S&P 500 index chart from Yahoo! explaining the idea. It reduces the damage significantly during the bear market, and one has only to examine the stop order level once a day, and increase the level if the index makes a new intraday high.
- On March 19th, 2002, S&P 500 reached 1173.94, and 7% stop loss of 1173.94 is 1091.76 [ 117394*(100% – 7%) = 1091.76 ].
- The stop loss order was placed with the broker and had not been increased because the index was going down since then. The stop loss was triggered on April 25th, 2002.
- On May 14th, 2002, MACD crossed over from below, and re-entered the market at 1097.28, which is still lower than previous high 1173.94, so re-use the stop loss level 1091.76.
- The stop loss was triggered again on May 20th, 2002.
- On July 31st, 2002, MACD crossed over from below, and re-entered the market at 911.62, which is significantly lower than previous high, so a new 7% stop loss level is used: 847.80.
- The new stop loss level was triggered on August 5th, 2002.
There are thousands of techniques to dynamically fine tune the stop loss levels and re-entry method to maximize profit, but they are beyond the subject of this article.