Volatile markets, stop-loss orders and goodbye

Tuesday, September 1st, 2015

During the last week or so, the stock market has been on quite the roller coaster, trading within the range of 1,230 points and reaching as low as 15,490 on the Dow Jones industrial average.

I was on many television and radio programs explaining what was happening and what investors should do. It is very hard to combine all the necessary information in short segments for investors to understand what they should do now.

It is less important to understand what happened — it was simply an overdue correction in the stock market up 10 percent or more.

It’s more important for investors to be concerned about what they should do during these pullbacks. I noted in my interviews the volatility of the 1,000-point drop, the 600-point decline for the day and the fear it created.

I tried to put things in perspective and relate back to Black Monday in 1987, when the market fell about 500 points, just half of the recent 1,000-point drop.

However, it’s important to understand that a 1,000-point drop today is about a 6 percent drop, but in 1987 the 500-plus-point drop represented about 23 percent. Now that is scary.

Today, I want to discuss a trading technique that uses stop-loss orders. These are orders that investors can place to sell their stock at a lower limit.

As an example, Company ABC is trading at $12 a share and you don't want to see a decline below $10 a share. By placing a stop-loss order at $10 per share, in theory, if the stock were to fall to $10 a share, your loss would be only $2 per share.

There are a couple of problems with this. First, investors may not understand that a normal stop-loss order does not always guarantee that $10 will be the actual selling price. If the stock were to open the next day at $8 a share, the stock would be short sold at $8 because there are no market orders for $10 a share.

Second, the bigger problem is that the stock can drop down to that $10 a share mark, come back up to $11 or even $12 a share for the day, and lucky you locked in a $2 loss.

Now this may not happen on the same day but it could happen the next day, the next week, or even the next month and all you have done is locked in a loss because you did not understand the fundamentals of the company or the stock that you invested in.

Keep in mind the odds are always against you because the market always goes up and it is simply a guessing game of when that will happen. It is my strong belief that the best way is to understand the fundamentals of your companies and realize the stocks will gyrate up-and-down.

However, the stocks (or small pieces of companies) that you own will do well going forward because of your research on these companies.

Another area that I did not have time to address in detail was about investors who have their money in stock mutual funds. These investors did not panic and sell mutual funds because they use a “buy and hold” strategy.

One problem with mutual funds is that you are a shareholder of the mutual fund and don't hold the securities separately from everyone else. What this means is that if you didn't panic and sell, you will share the stupidity of the 10 percent of shareholders who did panic and sell, while good-quality companies will be sold at lower prices.

Much of the volume and volatility was apparently coming from institutional funds, also known as mutual funds. These fund managers had to liquidate some of their stocks at fire-sale prices to raise the cash to send to their panicky clients.

Therefore, when the market rebounded, the stocks they sold at low prices went back up; the mutual funds no longer held those shares.

So what is an investor to do? In the management of our $165 million portfolio, we keep all clients’ accounts separate. If, by chance, one client does want to liquidate their portfolio, this will not affect anyone else's portfolio — they do not have shares in a mutual fund; each of our clients actually owns the shares in their own separate account.

It is another step to keep everyone's accounts separate, but it is far better than owning shares in the mutual fund and paying redemptions for people who get emotional about market declines.

Some investors are afraid to hold the individual securities, and they feel more comfortable investing in a mutual fund they think is safer only because it holds more positions. I only say this idea is not true.

However, if you hold a mutual fund, there are a couple of things you can do to check to see if you will be hurt by a market downturn as your co-shareholders panic and sell out of the mutual fund.

The first, and most important, thing to look at is the cash position of that mutual fund. An aggressive manager may hold from 2 percent to maybe 5 percent in cash. If that is the case, the mutual fund manager will have to begin selling off stocks to raise cash when redemptions pour in.

What the manager picks to sell can also make a difference. A good investor has no emotions when it comes to investing. A big mistake investors, including mutual fund managers, make is they will sell the losers and keep the winners with the big profits.

What this is doing is keeping your higher-risk companies with the higher valuations and selling the lower valuation companies that have a lower risk based only on the stock price.

Remember, with emotions we always want to buy high and sell low. Once again, your emotions are leading you in the wrong direction.

A mutual fund investor should check the holdings in the portfolio to see if they are well-balanced or if there any positions that are more concentrated and have high profits in them.

If you find more of a concentrated portfolio with high profits more times than not, that fund manager will sell the losers and keep the winners, which is really selling your low-risk companies first.

Maybe you can tell I prefer to buy and hold individual equities in our clients’ portfolios because of the extensive research that we do for each company on a continuous basis. I hope it is now apparent to you that mutual funds do not offer more safety, but actually have more risk.

Do you have a question or a company you'd like me to take a look at? Email me at Brent@WilseyAssetManagement.com!


Wilsey is president of Wilsey Asset Management and can be heard at 8 a.m. every Saturday on KFMB AM760. Information is provided by Reuters.