Financial Daily from THE HINDU group of publications
Sunday, Oct 23, 2005
Financial Daily from THE HINDU group of publications Sunday, Oct 23, 2005 |
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Investment World
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Stock Markets Columns - Simple Economics Stop-loss! B. Venkatesh
CONSIDER this. Your friend has bought 2,000 shares of Karur Vysya Bank at Rs 575 per share and 2,000 shares of Tata Steel at Rs 410 per share. Assume that his portfolio generated profits of Rs 2.5 lakh this month from purchase and sale of 10 other stocks. You know that Karur Vysya Bank has declined from Rs 600 to Rs 430 during the last 10 days, while Tata Steel has moved down Rs 20. Notice that the loss on these two stocks is more than the gains made on the 10 other stocks. This kind of experience is true for most of us. We make a number of small gains through the year. Then comes a market decline in which one or two stocks in our portfolio fall so sharply that they erode our profits and also result in loss of capital. Statisticians call such profit and loss distribution as left-skewed. Does your portfolio resemble such a distribution? If it does, be rest assured that your trading behaviour is not uncommon. Why? We suffer from what behavioural psychologists call loss aversion. That is, we hold on to our loss-making positions because we do not like taking losses. Yet, we exit our winning trades quickly, fearing that holding such positions longer will erode already available gains. In other words, we are risk averse when it comes to profits and risk seeking when it comes to losses. So, what should you do to overcome such trading behaviour? You should use stop-loss rules. That will help you exit loss-making trades early. Equally important is to run your profitable trades. You will then experience small losses frequently but your gains will be large enough to keep your portfolio profitable. (The author is Head, Research, Navia Markets.)
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