Diversification and Stop Loss Placement

What do the "experts" say about stop-losses? Granville, Weinstein, Dines, Magee, Crane, Edwards, Zweig, O'Neil, Wycoff, Sperandeo, Bernstein, Schwager, Murphy, and many others agree that stop-losses are an important part of any investment discipline. Some investment professionals, like William O'Neil of Investors Business Daily, say that a person should sell any stock that drops 8% below the buy price. They also maintain that an investor should hold about 5 stocks. That means a drop of 8% represents a hit to the portfolio of 1.6% for any single stock that drops 8%. O'Neil does allow investors with very large portfolios to hold a few more stocks. However, a person with $3000 is advised to hold no more than 2 stocks. Therefore, these smaller investors are being advised to tolerate a 4% impact on their entire portfolios when a stock is "stopped-out" with an 8% loss (8% ÷ 2 = 4%) in addition to a 3.7% brokerage commission for the sale (Schwab's standard rate). Older editions of his book imply these brokerage rates (the cheaper on-line rates came later) because they say the investor might save as much as 50% on commissions by using a discount broker (Schwab's normal discount rates are about 50% off standard brokerage rates). In his prime, O'Neil was one of the most successful short-term stock traders. His strategy recommends that investors focus on only a few stocks, watch those stocks carefully, and implement a strict 8% stop-loss discipline. This school of thought is dominated by short to intermediate-term traders. Granville agrees that such traders, who concentrate on a handful of stocks, should maintain close stops because the impact on the whole is greater if any one of the stocks gets out of control. He points out that a sharp reaction in just one of six stocks could wipe out the gains in the other five. A portfolio manager with a perspective very different from that of O'Neil is Marty Zweig (there is a point to all this, so please keep reading).

Marty Zweig has had one of the best all-time track records as a money manager. What does Zweig say? With regard to diversification, he cites academic studies showing that most of the advantages of diversification can be achieved by holding 8 stocks in 8 different industries. However, Zweig would try to buy 4 stocks for a portfolio of $5,000 or as many as 33 stocks in larger portfolios. With regard to stop-losses, in Winning on Wall Street Zweig says that it won't hurt a portfolio much if you get stopped out for a 15% loss, but that 20% is about all he would tolerate. He usually his places stops 10% to 20% below his purchase price, depending on his analysis of the stock's trading pattern.

Who is right? In a sense, they both are. If a person has only 5 stocks, and he does not know how to interpret chart patterns, a purely mechanical 8% stop-loss makes sense. However, there are times when an 8% stop would sell a stock just above strong secondary support. In such cases, it might be more prudent to wait for the probable rebound. That's how we once turned an 8% loss in Caterpillar Tractor into a 35% gain (in this case, substantial support was well below the 8% loss level but the overall price/volume pattern suggested strongly that the support would hold and the stock would resume its up-trend).

A person with 12 stocks who orders a 20% stop-loss (as per Zweig) would experience a "hit" on his entire portfolio of 1.66% if he is stopped out of any single position. However, Zweig also permits a very small portfolio to have only 4 stocks. In this case, his 20% stop-loss has an impact on the total portfolio of 5%. Both of these figures are similar to the figures proposed by O'Neil. Each has stop-loss parameters that are similarly related to the amount of diversification recommended. Triggered stop-losses will impact an entire portfolio 1.66% to 4% for most O'Neil accounts and 1% to 5% for most Zweig accounts. Again, the key concept is not the percentage loss permitted by a stop-loss but the total impact on the whole portfolio of any single stopped-out stock.

Most of the best investors in the business allow a single stock to have a maximum negative impact of 4% to 5% on the whole portfolio. Many of the best traders are much more restrictive than this. For example, stockdisciplines.com traders try to keep the maximum negative impact on a portfolio limited to no more than 1%. The amount of drop they permit an individual stock is loosely determined by the number of positions designed into the portfolio (it is related to the size of the position relative to the size of the portfolio). For example, a 4% to 5% drop in the entire portfolio would result if one stock dropped 60% to 75% in a 15-stock portfolio, 40% to 50% in a 10-stock portfolio, 32% to 40% in an 8-stock portfolio, 20% to 25% in a 5-stock portfolio, or 8% to 10% in a 2-stock portfolio. These figures show the benefit of diversification. It takes a 60% drop in a 15-stock portfolio to do the same damage as an 8% drop in a 2-stock portfolio. Though a 75% drop seems extreme, in the context of a 15-stock portfolio it is consistent with the maximum declines allowed by the disciplines of O'Neil, Zweig, and many others (in terms of its impact on the whole portfolio). More typical (for Zweig, O'Neil, et al) are the portfolio declines of 1.6% to 2% that occur when an individual stock drops 24% to 30% in a 15-stock portfolio, 16% to 20% in a 10-stock portfolio, or 8% in a 4 or 5-stock portfolio. As used here, a "15-stock portfolio" refers to the size of each position relative to the whole. The portfolio does not have to have 15 stocks in it at the time to be a 15-stock portfolio. The phrase means that each position is about 1/15th of the portfolio. That is, a portfolio of 3 stocks is still a 15-stock portfolio by design if each of the three positions is about 1/15th of the assets in the account. The other 12 positions are simply allocated to cash. In a 10-stock portfolio, each position represents about 1/10th of the total assets in the account.

The individuals I have cited fairly well represent the range of thinking of well-known and respected authors in the field. O'Neil believes that the typical individual investor who closely monitors and actively manages his account should limit himself to 5 stocks (no more than 8 for large accounts). This number is easier to monitor and it forces a sale of weak positions in order to buy stronger ones. Zweig, on the other hand, uses a considerable amount of technology in tracking his stocks. Hence, his disciplines work well with more stocks in the portfolio. Our own technology, disciplines, and procedures do the same for us. Thus, we can choose how focused or diversified we want to be.

Diversification is the key to more flexibility. In volatile markets, a stock may drop 9% or 10% and then quickly rebound to a 15% profit. A purely mechanical system might take an 8% loss on such a stock when a 15% gain was possible. The more diversified the investor, the more a stock can be allowed to decline before the investor has to eject it from the portfolio. That, in turn, enables the investor to reduce the number of unnecessary sales at a loss by basing decisions about where to place stop-losses on an evaluation of the support zones (regions where buying activity exert upward pressure) for each stock. It frees the investor from having to order mechanical sales at, say, 8% below the purchase price. If the portfolio is designed to have 15 positions, a stock can be given a little more latitude if it is falling and there is support nearby. Even a 15% loss in a single stock will impact the portfolio only 1%.

Copyright 2009, by Stock Disciplines, LLC. a.k.a. StockDisciplines.com

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