A professional investor will ordinarily spend a great deal of time deciding which stocks to buy for a portfolio. Typically, he will consider such things as: the fundamentals of the business; whether the stock is cheap or expensive relative to its peers; the health of the industry, sector and economy; the breadth of the markets; the timing of the purchase. At the end of this selection process, he will have a stock he likes and perhaps a target price he expects that stock to achieve.

Yet it seems many investors spend little or no time preparing a contingency plan in case the stock does not go up as they expect. To my mind this is perhaps the first question you should ask yourself; ‘What happens if I’m wrong?’, because with the best will in the world, no one can be right all of the time.

Investor Psychology

Of course this is not a question anybody really likes to ask themselves and this reticence has been identified as one of the reasons why markets are not as efficient as theorists would have you believe.

A new branch of study has become increasingly influential in recent years, as market practitioners have attempted to explain why markets can and do remain irrational for long periods of time, the study of Investor Psychology. Research in this field has identified many common mistakes investors make when managing their portfolios. Two of the most common are ‘fear of regret’ and ‘seeking of pride’.

‘Fear of regret’ is the reluctance to sell a losing position until it returns to somewhere near the price originally paid for it. Say you buy a stock at R100, but a few weeks later the price has fallen to R70. The temptation is to hold on in the hope that the shares will at some stage recover, whilst looking upon the missing R30 as ‘only a paper loss’. The truth of the matter is, the markets are probably telling you something important: it is a bad stock.

Business has changed

‘Seeking of pride’ is pretty much the opposite. In this scenario, you buy the stock at R100, it goes up to R120, whereupon you immediately sell it and tell your friends about the cool 20 percent you made in a week, right?

Wrong. If the stock goes up 20 percent, the market is probably telling you that something has fundamentally changed with the business. It is unlikely that the stock price will reverse in the short-term, and the weight of probability suggests more upside.

It is quite understandable that as an investor you can fall into either of these traps; we are all human beings after all. However, I believe it is vitally important to the successful management of any portfolio that an investor rids himself of emotional ties to his stocks and, instead adopts a rigorous methodology to manage downside risk.

So, how do you achieve this? By using a ‘stop loss and stop loss of profit' strategy.

Stop loss strategy

Going back to my earlier example, you have just bought stock at R100. What you should do immediately is set yourself a price below which you would resolve to sell the stock. If you decide you are prepared to lose a maximum of 10 percent, then the stop loss price will be R90. If the price falls below R90, you will sell.

Alternatively, let us assume that the second scenario plays out, and the stock rises to R120. Instead of selling and taking profits, you hold the stock. What you should do now is adjust the price that would trigger a sale.

If you decide to keep the 10 percent downside risk protection, your stop loss of profit would now be R108. You will continue to hold the stock as long as it keeps going up, and will continue to raise the safety net price, effectively ratcheting up the returns on the investment.

Clearly this is a simplified description of the process, and there are various other inputs that would ordinarily be factored into the decision.

These include:

• For an equity with a higher beta (i.e. with more volatility of returns than the market), you should consider allowing more latitude with the price action. This will stop you from being ‘whipsawed’ out of a position, that is to say, selling when your stop loss is breached without allowing for the fact that the general trend in the stocks price is still up, despite its wild price movements.

• The more uncertain you are about market conditions generally, the tighter your stops should be. This allows you to factor in any macroeconomic ‘top down’ concerns you may have. Remember that in a general market downturn, even the best stocks will go down.

Fundamental investors contend that it is impossible to predict future price movements from historical charts in an efficient market and have rubbished this type of investment strategy. But, whilst admittedly the process does use a certain amount of artistic licence in determining important price levels, irrational investors do exist, and you do see prices tend to be ‘sticky’ at certain levels.

Canny investors

Perhaps then, the canny investor should use both methods to achieve the best results, fundamental analysis to choose the best stocks, and technical analysis to time entry and exit points from the market.

One final observation I would make is that the stop loss and stop loss of profit strategy will not be successful all of the time. There will be times when a stock that you have just cut proceeds to go flying up past its previous highs, to your utter despair. But take heart, by being rigorous in your method and by systematically managing your portfolio to limit downside risk, you will tilt the odds of success in your favour and in the final analysis, that is the difference between success and failure.

Ian Leverington, CFA, is assistant investment manager at Ashburton Bespoke Portfolio Service.