What If Your Gut Is Wrong?

I got an email last week I was hoping I wouldn’t get.

TradeStops, the service I use to keep track of my stop-losses, sent a message telling me that Albemarle Corp. (NYSE: ALB), which I had recommended in Boom & Bust back in 2016, had closed below the stop-loss I’d specified for readers.

I wrote a quick note the next mornrning to my subscribers recommending they sell their shares of Albemarle and move on.

Albemarle was a good trade for us, and I have nothing to complain about here. Readers walked away with 50% gains in the stock, even after the recent correction. By any measure, the trade was a success.

But it still hurt me to tell the readers to part with the stock because I just knew the recent selloff was a market overreaction. Nevertheless, I told them to sell. Here’s why…

It’s possible (and probably very likely) that my gut was right and Albemarle’s recent selloff was the result of short-term profit-taking that would quickly run its course. The long-term macro trends supporting the stock were still in place and nothing had fundamentally changed.

But what if my gut was wrong?

As a morality tale of why it’s important to be systematic and not simply trust your gut, consider the case of billionaire hedge fund mogul Bill Ackman of Pershing Square Capital Management.

Ackman made the news this month because he laid off nearly 10% of his staff, including – gasp! – his personal chauffeur.

You know times must be tough when even the driver is getting canned. But that’s what happens when you lack basic risk management. You get burnrned.

Ackman lost $4 billion betting big – and wrong – on Valeant Pharmaceuticals. At one point in time, Ackman had nearly 20% of his portfolio in that single stock. But because he owned so much of it (and because so much of his identity as a manager had become centered on it) he couldn’t sell when things started to turnrn south.

From peak to trough, Valeant lost 97% of its value… and Ackman rode it all the way down.

To put that $4 billion loss in context, Ackman’s total assets under management have fluctuated between about $11 billion and $20 billion the past couple years. So, needless to say, that $4 billion loss represented a big piece of his investors’ capital.

Ackman’s cardinal sin was his lack of discipline, and it’s likely he’ll never fully recover from this. Let’s play with the numbers.

Gains and losses aren’t symmetric. If a stock drops 10% on you, a 10% gain won’t get you back to breakeven. You have to earnrn 11%.

If you lose 50%, you have to earnrn 100% to get back to breakeven.

And if, like Ackman, you lose 97% on a stock, you’d need 3,233% returnrns just to get back where you started.

I don’t know about you, but not many stocks in my portfolio returnrn 3,233%, or at least not in a timely manner. This is why it’s absolutely critical that you cut your losses early.

If you’re a good stock picker, you can easily recover from a 10% or even a 20% loss by simply making 11% to 25% on the next trade. That’s doable.

But you’re not going to recover from a 97% loss. That money is gone forever.

This brings up two critical risk management factors you need to consider whenever you make an investment:

  1. Position sizing
  2. Where to set the stop-loss

I think we can all agree that Bill Ackman had too much of his portfolio allocated to Valeant Pharmaceuticals. But how much is too much?

There is no hard rule here, but in my most aggressive portfolio I limit my position in any single stock to 10% of the portfolio. And in my less aggressive portfolios, I try to limit my exposure to 5% or less.

The way I look at it, if a 10% position were to go the wrong way on me and drop 20% to 25% before I was able to get out, the loss to the total portfolio would be a modest 2% to 3%. That’s an easily recoverable loss.

If you want to be a little more scientific about it, my friends at TradeStops have developed a sophisticated way to set position sizing based on historical volatility.

You probably know by instinct that something like Bitcoin – which can routinely move 20% or more in a single day – should be a smaller piece of your portfolio that, say, staid, boring ol’ Berkshire Hathaway.

But TradeStops will actually crunch the numbers for you and give you an allocation that’s optimized for current risk.

This brings me to the second consideration, knowing where to set the stop-loss.

Here, you’ll find different opinions, none of which are necessarily “wrong.”

William O’Neil’s Investor’s Business Daily recommends using a hard 7% stop loss on any new position, period. One size fits all. And there’s nothing wrong with that. A lot of investors have done well following O’Neil’s advice over the years.

A lot of newsletter writers recommend using a 20% trailing stop. And again, that’s not an unreasonable rule of thumb. It gives your investments a wide berth while also protecting you from large, devastating losses.

But again, my friends at TradeStops have gone a step further and put hard numbers to it. TradeStops will recommend an optimized stop-loss for each individual stock in your portfolio based on that’s stock historical volatility.

A more conservative stock might have a stop-loss set at less than 10%, whereas something like Bitcoin would have an optimized stop loss of around 50%.

In Boom & Bust and Peak Income, I use TradeStops to help me set my stop-losses. As a general rule, I’ll use TradeStops’ recommended stop-loss level as my baseline, though I may tighten the stops based on my market outlook or based on my specific objectives with that particular stock.

With a systematic approach, I take the emotion out of investing and, knock on wood, I’ve thus far managed to avoid taking any major losses in either newsletter.

If you’re interested in learnrning more about TradeStops, please click here. Me and Rodney recently sat down to talk with its founder and CEO, Richard Smith.

Charles Sizemore

Porfolio Manager, Boom & Bust

Charles Sizemore

Charles specializes in finding value opportunities and income plays outside of the mainstream stock market.