The number one rule is: cut your losses

THE JONATHAN DAVIS COLUMN

What are the most important rules that stock market investors should set themselves? Everyone will have their own list of favourites and you could argue the toss about which is the wisest all night if you so wished. For sheer profundity, it is hard to beat the famous Will Rogers adage: "If a stock ain't going to rise, don't buy it."

Ask a different question, however, and the answer is easier. Which golden rule of investment is broken more often than any other? That prize surely has to go to one of the oldest and wisest sayings in the game: "Cut your losses and run your profits." It sounds so simple, yet nothing in practice proves quite as hard and professional investors are just as prone to breach the rule as are amateurs.

So too, it now appears, are tipsters. I am indebted to Mike Mitchell, whose excellent publication, Tiptracker, I had occasion to mention last year, for some fresh evidence of how important and costly the rule can be if it is forgotten. In his latestquarterly survey of share tipsters' performance (0181-747 9497 for details), he looks at the overall performance record of newsletter and national newspaper tipsters since he started monitoring their results two years ago.

Several things are striking about the results. One is the huge range of outcomes of the individual tips. On the plus side, he found more than 30 tips which produced a capital gain of more than 150 per cent over the period. The best tip of all, Blacks Leisure, has risen by 485 per cent since it was highlighted by Inside Track, a newsletter that monitors directors' dealings in their own company's shares. A number of the better specialist newsletters, such as Techinvest, consistently pick more winners than losers and may well justify the cost of a subscription.

At the other end of the scale, there is one wipeout, the shoe company Chamberlain Phipps, which went bust despite having been picked as one of a national Sunday newspaper's shares of the year a few months earlier. A second company, the textile firm Hamlet, has gone into administration and may yet join the ranks of complete wipeouts. (Honesty compels me to point out that national newspapers generally have a distinctly lacklustre record in the field of share tipping.)

A total of 45 share tips have so far lost more than 70 per cent of their value since being tipped. The list of the 50 worst tips includes more than its fair share of small technology companies, such as Pace Micro Technology, which started to lose money from the moment they arrived on the market as new (and overpromoted) issues.

But the extraordinary thing about the statistics is how important stopping losses is in determining a tipster's overall performance. Mr Mitchell points out that a simple but automatic stop loss rule (say selling a share once it had fallen by 20 per cent) would have improved the worst tipsters' performance by a substantial margin. Some of the best tipsters do use such rules. Yet if you look at the 50 worst-performing tips of the past two years, in only one case out of ten did the publication which tipped the shares advise its readers to sell and cut their losses.

Now this may only be telling us something about the commercial realities of life in the newsletter business. No tipster is likely to relish drawing attention to his own failures. As it is, too many of the readers who are drawn to buying tipsheets do so with inflated expectations of what stockpicking can do for them. A typical tipsheet reader hopes to make 50 per cent a year through picking winners, whereas in practice, as Tiptracker's calculations confirm, even it you are smart enough to pick one of the handful of quality newsletters that does consistently come up with good new ideas, 15 per cent a year is a far more realistic expectation.

And the reason for all this comes back in the end to the wisdom of the "cut your losses and run your profits" rule. The trick in making money from the stock market lies only partially in picking individual winners. What you have to do is to put together a profitable portfolio of shares. You need to find one or two exceptionally strong performers and stay for the ride as they rise: a really good share may rise for longer than you expect.

But what you also must do is to accept that even the best stockpickers will always come up with their fair share of duds. The important thing is to avoid allowing the dogs to cancel out your winners and drag down your overall performance.

Suppose you have a portfolio of 10 shares and your target is to generate a 15 per cent return. One of your shares falls by 20 per cent. In order to generate an overall return of 15 per cent, how well do your other nine shares now have to perform? They now have to grow by an average of 17.8 per cent to offset the impact of the laggard. As the table shows, if the share falls 50 per cent, the hurdle rate for the other nine rises to 22.2 per cent. And if your target return happens to be 20 per cent a year, well, let Mr Mitchell speak for himself: "If your target average is 20 per cent, any single loss above 30 per cent means you are looking for your nine winners to beat Warren Buffett's 40-year average of 25.6 per cent. You are no longer on Mission Achievable, you are on Mission Impossible."

Dreamers will always dream on about making a quick killing in the market and retiring on the proceeds. Realists will say: "Let's look for the next Blacks Leisure, and when we find one, let's make sure we get the best of it by hanging on until there is some clear-cut reason for selling." But they will also keep an eye on the dogs in their portfolio and chuck them out if the prices starts to fall through the floor.

Loser falls: how much the other nine must make

15% target 20% target

-10% 17.8 23.2

-20% 18.9 24.4

-30% 20.0 25.6

-40% 21.1 26.7

-50% 22.2 27.8