Trading Strategies: If you want profits, make sure you cut your losses

Much of the advice you read about stock market investment is evangelical claptrap, because, in the absence of a precise science, human nature likes to invent rules and axioms.

Much of the advice you read about stock market investment is evangelical claptrap, because, in the absence of a precise science, human nature likes to invent rules and axioms. As spring approaches, "sell in May and go away" is a particularly popular mantra that is sure to be wheeled out to highlight the frequent slide of stock markets during the summer months.

However, if you can only stomach one piece of pseudo-wisdom, the maxim to abide by, above all others, is "cut your losses and let your profits run".

Research repeatedly shows that an investor's overall losses are much more likely to be down to a small number of large hits than a series of trivial disappointments. Few investors have the discipline to ruthlessly bail out of loss-making positions. Instead, they hang on, in the secret belief that the share will somehow edge back up.

It concentrates the mind no end to remember that if you lose half of your money on a trade, you will need to make a full 100 per cent on your next investment to break even. Similarly, if you lose 35 per cent of your capital, you'll need to make 53.8 per cent on the remaining portfolio to get back to square one.

An easy way to avoid heavy losses is to set a stop-loss for each shareholding with your broker, which will automatically trigger its sale should the share price fall in value, perhaps by a predetermined percentage, such as 10 or 15 per cent. If you select a 10 per cent stop-loss, say, you will only have to make 11.1 per cent on your next investment to recover.

To get the best result, a dynamic trailing stop will protect profits as a share rises. This works by raising your stop-loss as a share price advances. On a stock priced at 100p, your sell trigger might be 90p. But once it moves to 110p, for example, you move the stop loss up to 99p.

This year, profit warnings in sectors such as retail and media, traditionally favoured by private investors, have shot up, in many cases wiping out gains that have taken years to build.

For instance, EMI's shares had nearly tripled in the two years until February, when the music publisher issued a profits warning and the stock plummetted from 281p to 236p. Had you set a trailing stop loss of 10 per cent, you would have got out at 253p.

Similarly, shares in Centurion Electronics, which makes car entertainment systems, halved to 30p on its March warning, but a 10 per cent stop loss would have seen you clear at 54p.

It would have been a similar story at most companies issuing profits warnings this spring. At William Morrison the sale of your shares would have been triggered at 201p, when the price fell from 223p to 195p; at Boots your position would have been closed out at 623p, when the shares plunged to 610p from 692p.

However, a stop-loss of 10 or 15 per cent will generally cut in only when a drop is so big that further falls become self-fulfilling. Take Premier Foods, the makers of brands such as Hartley's Jam and Angel Delight. Last October, its factory in Bury St Edmunds burned down, creating a run on Branston Pickle.

The share price dropped from about 230p to 222p and then subsequently recovered to 292p.

But in February, just when the management must have thought it had had its fair share of bad fortune, Sudan 1 chilli dye was found in its Worcester sauce, leading to the recall of more than 350 products from supermarkets across the country. The shares tumbled to 263p.

Had you implemented a trailing stop-loss, your shares would not have been sold. But this time you would have been relieved, because Premier shares have been fantastically resilient and now top 305p.

With £100bn of private equity currently looking for deals, an unemotional exit plan is also required to handle the disappointment of abortive bids. A stop-loss system would have closed you nicely out of Uniq, the chilled food specialist which makes the Count On Us slimming range for Marks & Spencer.

Its share price has dropped in a staircase pattern from 213p in December to less than 150p, as, one by one, potential suitors have taken fright at its £102.3m pension deficit and walked away.

So is there anything in the "sell in May, don't come back until St Leger's day" advice? The short answer is: rather a lot. For the past four decades, you would, on average, have made nearly 10 per cent holding shares from November until April, while markets from May to September have typically drifted sideways.

Historically at least, the data suggests that you could do worse than join the ranks of unemployed finance directors enjoying a summer break away from a screen.

In fact, rather than reinvesting on St Leger's day (the day, usually in mid-September, when the St Leger horse race is run at Doncaster), it has actually been more profitable to leave it until the first day of the shooting season, 1 October. That final fortnight in September makes all the difference, because it marks the end of the US mutual fund year when funds sell stock like crazy.

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