'Twas back in the dim and distant days of 1995 when H&G enrolled a new member. Nothing particularly spectacular about that, except that he was the first member of the club to have any previous investment experience.

John Mitson is his name, and as he carries out the bulk of the club's research we now call him the "Chief Science Officer".

He introduced us to stop losses as a way of protecting profits made, a system which, on the face of it, seems fairly sound.

For those who don't know, a stop loss is a way of limiting losses. A simple example would be as follows.

Shares are bought at £1 each. The club may decide that they are prepared to let the price fall 30% before selling, so therefore if the price fell to 70p, the sale would be effected. If the price moved up to £1.50, then the stop loss might move to £1.05, etc. etc. I'm sure you all understand the principle.

Now this seemed like a jolly good wheeze. After all, everyone wants to limit risk as much as possible, don't they? And several investment gurus strongly advocate a stop loss system, and they've made loads, so it must work, mustn't it?

Well, yes, to a degree. But there are problems. This system relies solely on the fact that it is the share price which drives the desire to buy or sell, not the company itself nor any other aspect. Purely the price.

Now there are occasions when the "people that know" will sell a share a day or two in advance of a profit or earnings warning. On these occasions, companies (especially small ones) will suffer adversely with the share price. A stop loss might allow the club to get out ahead of the real bad news.

But there are many, many factors that drive the market. The Brass Monkey club found that out to their cost, having invested £10,000 at the height of the 1997 bull run, only to have 30% wiped out within a couple of months. That should have triggered the stop loss system, except that particular club did not adopt one, otherwise we would have just invested and lost and invested and lost for the first 2.5 years of our existence. Does the law of diminishing returns mean anything?

H&G decided to ignore its stop loss system during the summer of '97 when the entire market fell around our ears for a few weeks, and everything, yes everything, would have had to have been sold. But these prices had slammed right through our stop-loss, and we would have lost shedloads of money. We therefore took a view and let the whole lot ride. This has paid massive dividends for the club since as the stocks have recovered and climbed new highs.

The stop losses were gradually re-introduced stock-by-stock over the course of several months (years in some cases) but then we found ourselves in a similar position. We would set a stop loss, the market would have an awful day or two (across the board), and our shares would collapse. We should have sold, but we didn't, because the fall in price was universal, and not stock-specific.

This is where an individual has an advantage over a club. A private investor can buy, sell, or whatever, without reference to a committee or the club members. So, if the market is looking a bit dodgy, he can take profits and sell, then decide for himself when to put it back, how much and into what.

The club, however, will have to wait until the next meeting at least before re-purchasing, and the timing of this may not be to the club's benefit.

But hang on a minute. Should we, as Fools, be that influenced by just a share price? Surely a significant drop in price without any significant detrimental change to the company should be seen as a buying opportunity, should it not? This Fool says yes.

Consequently, after 3 years of selectively implementing and then ignoring our stop losses, we decide to abolish the system altogether. We now look at every share on its merits on a monthly basis, which seems to work far better.

There is however one scenario in which stop losses (and stop gains) are not so much important but pretty much essential, and that is in the last year or so of a limited life club. If the club is coming to an end, then obviously any gains will want to be maximised. The time element of the investment is no longer applicable, so there is no time for a share to recover if it falls, and if a share scales new heights you might want to sell up and cash in to protect the profits. Pretty pointless applying LTB&H techniques in those circumstances.

I would be interested to know if other clubs operate a stop loss system and how it works for them.

All comments, as usual, to the Investment Clubs discussion board.

Where Next?

USEQEQWEB10 32 ms