Research has shown that what separates the successful fund managers from the rest is knowing when to sell their losers and when to take profits.
On the face of it this may seem elementary but as humans we are programmed by design to be poor investors. Research by two economists (Daniel Kahneman and Amos Tversky) found that investors are happier taking risk to avoid losing money than they would to increase a profit. Or in other words they will hold onto their losing investments longer than they should. The reason for this is that human psychology drives us to be consistent. Our desire to be consistent has been integral to our ability to conquer our environment and dominate the planet. Over thousands of years humans have learned to work for the greater good of the group rather than the individual. For this to work we had to be able to rely on individuals to do what they said they would. It also requires a predictability in collective behaviour, or in other words 'consistency'. This consistency is what makes it difficult for us to change our views. Part of what it means to be human is our ability to be consistent.
When it comes to investing this means that when we get it wrong we will naturally hold on to losing investments for way to long because we can't stand to take the opposite view to the one we held previously, which was that the investment was a good one. The way to solve this is to use an objective tool such as a stop loss.
On the flip side we also tend to hold on to our winning investments far too long, forgoing profits we've built up when the market inevitably turns. So it's just as important to know when you are no longer right as much as it is to know when you are wrong. Again a certain type of stop loss can be used to objectively help DIY investors know when to sell their winners.
The 80-20 investor trailing stop loss
The 80-20 Investor stop loss is what is know as a trailing stop loss alert, as opposed to a traditional stop loss. A traditional stop loss works with reference to only the price you paid for an investment.
Let's say you bought a share for £10. A 5% stop loss will only trigger when the price falls to 5% below the price you paid. So in this example a 5% stop loss will only trigger if the share price falls to £9.50. However, your share price could have risen to £50 before the market crashed without you realising and leading you to lose all your profits . The first you'd know about the crash is when the value of the share fell below what you paid for it and the stop loss was triggered
However, a trailing stop loss works with reference to the highest price the share attains while you hold it. So for example, if the share price rose from £10 to £50 you would only get a 5% trailing stop loss alert when the price hit £47.50, i.e. 5% below its high of £50. That way you have the choice to sell and make a huge profit, while at the same time avoiding the worst of the market sell-off.
80-20 Investor issues 5% trailing stop loss alerts, via email, for the funds within the Best of the Best Fund Selection each month. The fund price is monitored for each of the funds until the next time the Best of the Best fund list is updated.
How to use the 80-20 Investor stop loss alerts
The 80-20 Investor stop loss alerts are sent to members automatically based upon the funds that have made it into the Best of the Best Selection for that month, regardless of whether they invest in them or not. The stop loss alerts should not be seen as advice or an instruction to sell your investments, they are for information purposes only.
However, they give you an early warning signal that markets may be turning and to review your fund holdings. When I run my £50,000 portfolio live for 80-20 Investor members, which has comfortably outperformed the market and professional fund managers, I also use the stop loss alerts as a gauge of market sentiment for individual fund sectors and whether I should be looking to take profits.
Don't forget you can view all historic 80-20 Investor stop loss alerts here.