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Holly LaFon
Holly LaFon
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Sierra Mutual Funds Commentary - A Portfolio Manager's Resolution for Investors: Trailing Stops

By Terri Spath, chief investment officer

January 17, 2019 | About:

A new year brings with it the elation of a renewed start. We proclaim resolutions about how we will make this year better than the one that just concluded. After the volatile close to 2018, investors should now be doing the same. Fortunately, there is the trailing-stop.

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 losses1, 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!

LOOK OUT BELOW!

Maximum 3 Day Drawdown by Asset Class

Source: yCharts, Reuters, Sierra Investment Management. December 7, 1984 to August 27, 2018

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

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.

PORTFOLIO POSITIONING

Recently, we have often been asked “what is driving this volatility”? While we can’t point to any one factor, it’s clear that markets are vulnerable, and they could be reacting to any number of things: headlines about trade, or tweets about tariffs, or the Federal Reserve’s latest news conference, as examples. Our approach is to react with discipline to what the market is telling us.

Using trailing-stops gives an early warning signal for when to sell. In the last few months of 2018, our stop-losses gave many early-warning signals and we exited positions, avoiding further losses. It’s also important to seek out how to make money in falling markets and our rules-based approach also led to significant position in intermediate and long-dated Treasuries where prices were rising in the flight-to-quality environment.

Our trailing stops prompted us to bid adieu to many holdings last year. We also say good bye to 2018. As we turn the page and enter 2019, our portfolios and strategies began with high cash positions and opportunity to participate in new rallies. The New Year brings elation of a renewed start, but just as last year and all the years before that, we resolve to always stick with our trailing-stops. We wish everyone a prosperous New Year.


1In 2018, for example, on days when the S&P 500 was up, the gain averaged 0.65%, but on days when that benchmark fell, the loss averaged -0.78%.

Past performance does not guarantee future results. Investors cannot invest in an index and unmanaged index returns do not reflect any fees, expenses, or sales charges.

This publication is for general information only and is not intended to provide specific advice to any individual or institution. Some information provided herein was obtained from third-party resources deemed to be reliable.

About the author:

Holly LaFon
I'm a financial journalist with a Master of Science in journalism from Medill at Northwestern University.

Visit Holly LaFon's Website


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