OPAM: Managing risk with Trailing Stops
As we have been reminded, the market usually drops faster than it rises. The cliché is that the market “takes the escalator up and the elevator down,” and while not always true, the stats do seem to bear this out. Daily percentage equity gains are on average smaller than daily percentage equity losses, and even asset classes considered “safe” or “risk off” can have astonishingly quick drawdowns. Long government bonds, for example, can and have tanked over 5% in 3 short days!
Armed with the knowledge that corrections can be swift and merciless, we have often spoken of the importance of discipline within any investment approach and how a tactical, rules-based approach can significantly outperform. This is where a simple yet effective tool like the trailing-stop comes into play.
A trailing-stop is a rules-based sell level that moves up as a given security trends upward and is executed when the trend reverses downward. In this manner, investors may benefit from productive rising trends and step aside in an effort to avoid significant declines. Using a rules-based, trend-following strategy offers the opportunity to participate in the vast majority of an upside move while also managing downside exposure. Below is a visual representation of the lifespan of a position in a particular asset class with our entry and exit points illustrated.
A Sample Bond Mutual Fund Holding Period
For illustrative purposes only. There is no guarantee that any investment strategy will achieve its objectives, generate profits or avoid losses.
Sometimes we are asked, why we don’t sell at the top price? Most can’t do that consistently. However, you can see that utilizing a trailing-stop seeks to reduce downside impact and any gains left on the table are de minimus compared to gains realized and losses avoided. At the end of the day, the trailing-stop is a tool that helps investors like us stick to a disciplined process and sell discipline. While not perfect, rules-based selling can help investors limit both the effect of rapid drawdowns and the possibility of permanent destruction of capital.
Check out this Market Commentary from Terry Spath, CFA, Chief Investment Officer & Portfolio Manager Ocean Park Asset Management.
A Portfolio Manager’s Resolution for Investors: Trailing-Stops – January 11, 2019
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