Investment School: Importance of Stop Loss

Importance of Stop Loss

Sensex at 18 months low and global markets feeling the heat of us economic failure, and most of us have accumulated loss in our portfolio.We need to sit and analyse if we can digest the current loss and if we can digest more loss or should i cut back loss and move to fixed return investments.

This is required because each one of us have a certain level of risk appetite and we should ensure that our investments are bearing a risk which is affordable by us. All of us invest our hard earned income and hence we should have a comfort level with your investments.

Any investment made should have the following attributes associated with it.

1. Time period of investment.
2. Stop Loss.
3. Target Amount.

Lets take a usecase and analyse it. Ram makes an investment of 2 lacs in sensex(sensex taken for easy reference) on Oct 1st 2007.

Time period of investment = 3 years
Stop Loss = 10%
Target Amount = 3 lacs

Current Value of investment = 1.5 lacs

What is stop loss?

Stop loss is usually expressed as a %age of total investment. In this case it is 15%. So when your market value of investment reaches 90%(100-10) of your initial investment, you should book your losses and exit from that investment.In this example, Ram should have booked loss when it was 1.8 lacs (10% 2 lacs = 20,000) and exited his investment.

However he continues to hold his investment and his loss has increased from 20,000 to 50,000 now. There are so many Rams out there in the market who does not have a well defined stop loss planned for their investment and hence accumulate their losses.

How stop loss is useful?

Emotions should never play a part in one's investments. When you invest a certain amount and have your target set, you should exit when your target is achieved. In the same case, you should exit when your stop loss condition is also met.

Stock market is all about emotions but an intelligent investor should never get into that trap.

What is the common mistake committed?

Most of the investors, when experience a loss in their portfolio and if that loss is more than a specified stop loss, expect the market to recover and expect their investments to come back to profit at some point of time. But they never know "when will their investments be back in profit again". They live on hope of recovery.

Instead of living on hope of recovery, an investor should cut his losses and analyse the investment he had made and what are the areas that he can improve upon so that his upcoming investments are made properly.

Capital Protection Vs Hope of Profit

When an investor is in loss, he is expecting the market to recover and go back to highs but at the same time he has already lost his capital and he is bearing the risk of losing more of his capital. Capital protection should be given highest priority over expectation of recovery when an investor is experiencing a loss.

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