Two Rules to Avoid Big Losses When Investing in a New Stock
The last thing anyone wants to happen when investing in a new position is to experience a large loss.
To prevent this, I follow two pieces of advice borrowed from trend followers.
- Start with a small position
- Then average up into the position if the price action of momentum is favorable.
I want to reduce the magnitude of my loss at the start if I’m wrong in my research and I’m willing to give up some returns at the beginning to insure that my investment will work sooner and other money is flowing to it too.
Starter Position
My standard starter position is 1/3 of a full position. Yours will be different. This is the system that works for me right now.
I don’t want to own more than 20 positions so for simplicity's sake let’s assume each position is equal weight at 5%. A standard starter position would then be 1.67%.
In practice, my portfolio will not be equal weight.
If I’m wrong about a new position and it declines after I start investing then I’ve limited my capital at risk.
Yes, I am sacrificing gains by not being fully weighted to a position if it starts moving in my favor from the start.
But I rather take small losses than large ones.
In the book The Art of Execution, the author cites a study by Professor Frazzini that those portfolio managers who took frequent small losses tended to have the highest long-term returns.
Professor Frazzini supports the Assassins’ approach too: it shows that the highest investment returns were achieved by those investors that had the highest rate of selling out of losing positions. Those that realised [sic] the least amount of losing positions experienced the lowest returns.
But as I’ll get into below I have another set of rules involving momentum to avoid putting capital to work in potential value traps.
Momentum
Momentum is one of the persistent factors that outperform the market.
From MSCI Focus: Momentum
Why not use this knowledge to our advantage when starting a position?
Both 6-month and 12-month momentum factors, outperform the broader market.
From MSCI Focus: Momentum
For a starter position, I first look at 6-month momentum. If it has positive 6-month momentum then I will put capital to work.
The hope is that 6-month momentum turns into 12-month momentum too. It is during this phase that I want to put more capital into a position that is moving favorably.
An adjustment I’ll make is if a new position has positive 6-month and 12-month momentum and its relative momentum is better than the S&P 500. It is outperforming the S&P 500. Then I’ll increase my starting position to ½ of a full position.
A study by Iván Blanco, Miguel De Jesus, and Alvaro Remesal found that the stocks having both positive 6-month and 12-month momentum had the strongest outperformance.
If a stock has both good 6-month and 12-month momentum, the demand of the 12-month momentum investors and the 6-month momentum investors accumulates, and we should expect even better performance for these stocks than the stocks that only show up on a 12-month momentum screen. So, what the Blanco and his colleagues did was a simple exercise of looking at the 10% best and worst stocks based on both 12-month momentum and 6-month momentum. Then they looked at the stocks that showed up in both lists and the stocks that showed up only on the 12-month momentum list. The results of going long the best 10% and short the worst 10% for the traditional 12-month momentum strategy are already impressive, but if one selects only the stocks that overlap and appear in both the 12-month and 6-month momentum strategies, it gets even better. The additional demand for these stocks from a different group of momentum investors leads to outperformance... [emphasis added]
If I’ve found a high-quality stock that is undervalued and/or reasonably priced with both positive 6-month and 12-month momentum, I’m willing to put a little more capital at risk. I could still be wrong so I’m not putting a full position to work right away.
The common objection to this approach is if a new position works right away and I don’t have a full position then I’m missing out on potential gains. That’s true. But this thinking is based on the fear of missing out. That is why I have a second set of rules to add to a position if it does work right away.
It would be nice to have a full position in this scenario and capture all those initial gains, but I’m more concerned about avoiding big initial losses.
