Benefits of a stop-loss strategy

When investments unexpectedly lose a lot of value, a stop-loss strategy can be a seen as a defensive strategy that is usually cheaper than the use of derivatives.

Up until May 2008, investors enjoyed good returns and many felt that their investment portfolios would always move up at a similar rate to that of the market since 2003. There had been a few minor pullbacks in the ALSI during the past five years but these were followed quickly by sharp and sustained recoveries. Then, since May, the ALSI lost over 40% in eight months with no recovery in sight.

History repeats itself

This means that it will have to gain 67% to regain its nominal value. This has not been an isolated occurrence -the table below describes eight downturns in the ALSI, the duration of the downturn and subsequent recovery to the previous high.

Conventional growth since 1960

Had an investor simply invested in the ALSI from January 1960 at a level of around 95 and held that index to January 2009 to its current level of around 20000, they would have enjoyed a return of 11.5% per annum and would have grown R100 to over R21 000.

Growth since 1960 by applying a stop-loss

A stop-loss strategy is the process of selling a holding in a unit trust or share once it has lost a predetermined percentage from the highest point it reached.Let's say an investor employs a strict stop-loss strategy and sold at 10% from the peak value in each one of these eight drops and bought back in once the index had recovered by 15% from its absolute bottom. Furthermore let us assume that while the investor is out of the ALSI they invest at a fixed rate of 7% per annum.

With the use of a stop-loss over those eight drops the annual return would have increased from 11.5% to 19.9% and the R100 would have grown to over R700 000. In addition to greater performance, the volatility would be significantly lower.

The critical factor

While clearly oversimplified, this example illustrates that by avoiding major market corrections, the return will be significantly greater over time and the volatility/risk will be significantly reduced. The critical factor underlying this is finding investment managers who have a proven track record of actively employing a stop-loss strategy.

 
                           NumberTime taken for investor to recover money

Period of JSE Drop     No of Drop   Days   Month(30 days)   Years    Maximum

                                                                                                           Drawdown 
                                                                                                           During

                                                                                                           Drop
-------------------------------------------

----------------
Jan 1960 - Oct 1962            1            1004          33                  2.8       35.8%
Apr 1969 – Feb 1974          2            1795          60                  5.0       61.7%
May 1974 - Apr 1979          3           1826           61                  5.1       42.8%
Oct 1980 - Dec 1982           4            821            27                  2.3       46.7%
Aug 1987 - Jul 1989             5            731            24                  2.0       43.9%
Apr 1998 - Nov 1999           6            610            20                  1.7       40.2%
May 2002 - Sep 2004           7            1249          42                  3.5      32.3%
May 2008 - Current               8            245            8                    0.7      35.8%