Last week, I began part one of this series with a great Wall Street maxim. It’s only fitting that I start part two with one of my favorite investing quotes ever, credited to John Maynard Keynes: “The market can stay irrational longer than you can stay solvent.”
In addition to being the father of a widely used school of economic thought (Keynesian economics), Keynes was an accomplished investor.[ad#Google Adsense 336×280-IA]There’s little doubt that he knew a thing or two about the consequences of being wrong and/or stubborn.
As investors, we hate being wrong. We probably hate admitting that we were wrong more than just actually being wrong.
Last week, I discussed crafting a sell discipline for gains. But what about losses?
When crafting a sell discipline strategy for losses, you must first determine how much you are comfortable losing on a percentage basis. Professionally, my threshold is between 15 and 20% and, again, it all depends on the stock’s underlying fundamentals.
If it’s a widespread correction and the fundamental story on the stock is still intact, there’s no reason to sell. If the fundamentals change materially, it’s time to make a move.
Here’s a personal, real world example. And, just like last week, it’s an oil stock.
For nearly five years, I held shares of ConocoPhillips (NYSE: COP) in a dividend growth strategy portfolio I manage for my clients. I covered the stock for StreetAuthority quite a while back and I have always been a fan of this company. However, when “Oilmageddon” caused by plunging crude prices hit just about every publicly traded energy stock available, even a high quality name like ConocoPhillips couldn’t escape injury.
Originally, I bought the stock around $40 and was collecting a dividend yield of about 5.4%. Over the next five years, COP raised the dividend, on average, 5.3% annually which, effectively, brought the average dividend yield for the holding period to 6.6%. Then came the fundamental change.
Last month, after reporting a fourth quarter loss of 90 cents per share, the company slashed its quarterly dividend from 73.5 cents per share to 25 cents per share: a haircut of 66%. The investment policy of my dividend growth strategy portfolio mandates that if the dividend is cut or eliminated, the stock can no longer be held in the portfolio. However, when the stock was beaten down to nearly $31 after the announcement, I was still under my 20% loss threshold.
Rather than sell immediately, I watched and waited. In just a few weeks the price of the stock bounced and I sold across the board at $34 — booking a 15% loss. But once I went back and looked at the dividends we had collected over a five year period, the picture got a bit rosier.
On average, COP shares brought an annual dividend yield of 6.6% while I held them, thanks to the regular dividend increases. That came out to be a cumulative return of 33% over five years. Thus, the 15% loss was erased, resulting in a net gain of 18%. Thank goodness for dividends!
Risks To Consider: Things don’t always work out this way. Our instincts aren’t always correct. At the time, I felt that the selling on the stock, and the oil sector as a whole, was probably reaching the point of being overdone. In my experience, typically, some kind of bounce is in order — which is exactly what happened. I spend a lot of my days with my finger on the button, but most individual investors don’t have that luxury. Trailing stops are designed for that — use them if you’ve got a set price in mind for getting out of the stock
Action To Take: To quote the Oracle of Omaha, Warren Buffett: “a stock doesn’t know that you own it.” A real, defined sell discipline is a must for any serious investor.
We are taught to let our winners run. But there’s nothing wrong with taking some of your gains off of the table to manage risk. On the other side of the coin, we’ve got to have an idea of where we get out if things don’t work out as we planned with an investment.
Just as you determine why you’d buy a stock, figure out why you would get rid of it. My personal plan, typically, is dictated by a change in fundamentals which drive the reason why I invest in a stock in the first place. Set an actual, hard number on the downside (a percentage) should that condition be triggered and use stop loss orders in necessary.
Also, evaluate the income stream you received over the holding period. It might make you feel better. Heartache and, hopefully, money, can be saved.
— Adam Fischbaum[ad#sa-trader]
Source: Street Authority