This is the editorial of our monthly Shareholder Yield Letter published on 2023-10-10. Subscribe here and receive it in your inbox on the first Tuesday of every month.

More details about the newsletter can be found here: An ultimate guide to large cap investment strategies

This issue delves into the implementation of the trailing stop loss rule in your portfolio and what you should AVOID at all costs!

But first, let's discuss the portfolio changes.

Portfolio Modifications

Purchase Four – Offload One

Four new suggestions this month as the MSCI World index is above its 200-day simple moving average.

The first is a Hong Kong-based company involved in the production and distribution of consumer food items with a shareholder yield of 7.1%, share repurchases of 0.6%, and it distributes a 6.5% dividend.

The second is a Japan-based firm focused on the exploration, development, production, and sale of oil and natural gas products with a shareholder yield of 9.1%, share repurchases of 5.8%, and a 3.3% dividend yield.

The third is a US-based financial services organization with a shareholder yield of 9.1%, share repurchases of 5.8%, and a 3.2% dividend yield.

The fourth and final recommendation is a Hong Kong-based producer and vendor of beverages with a shareholder yield of 9.6%, share repurchases of 4.0%, and a 5.6% dividend yield.

Stop Loss – Offload One

Sell HP Inc. with a loss of 8.6%.

How to Implement the Trailing Stop Loss Rule

Here's a query from a subscriber that could pique your interest as well:

“I was unaware of the distinction between your 20% Stop Loss practice and simply setting a 20% Trailing Stop Loss limit within my broker’s system until I contemplated it for a while. Then I realized that the primary disparity lies in the fact that, while you scrutinize the last month – in other words, 20 or so, closing prices – the latter trails all intraday fluctuations of a stock, thus being much more volatile (and executed more effortlessly). I believe it would be beneficial for the community if you could delve into this in more detail in a forthcoming newsletter.”

Before addressing the question, let's lay some groundwork.

You and your stop losses

We receive numerous inquiries about the stop-loss approach we adopt in the newsletter; thus, I figured you might also want to delve deeper into it.

First, some context.

My Discontent with Stop Losses

Until approximately 2015, I refrained from employing a stop-loss strategy.

Some testing led me to believe that a stop-loss strategy leads to lower returns, even though it mitigated volatility (significant price fluctuations upwards or downwards).

However, we are constantly sifting through research, and at the beginning of 2015, I stumbled upon three papers that examined stop-loss strategies with remarkably insightful outcomes.

Findings of the Research

I won't bore you with all the intricate details here; you can peruse the complete article here: Realities about stop-losses that nobody wishes to acknowledge

The research unequivocally demonstrated the efficacy of stop-loss strategies!

 Here are the key highlights:

• A simple stop-loss strategy yielded superior returns while substantially reducing losses
• A trailing stop loss surpasses a traditional stop-loss (loss from purchase price)
• The optimal trailing stop-loss percentage is 15% or 20%
• If you employ a pure momentum strategy, a stop-loss strategy can assist you in completely avoiding market crashes, and even earning a modest profit while the market undergoes a 50% slump
• Stop-loss strategies diminish wild downward movements in your portfolio, thereby substantially boosting your risk-adjusted returns.

The Arduous Part – Emotional Factor

Even if you are convinced of the concept of stemming your losses, the arduous aspect of implementing it is to overcome your emotions and refrain from holding onto a losing stock when a stop-loss level is reached.

This is crucial because for a stop-loss strategy to work in your favor, you MUST adhere to it, repeatedly.

I'm sure you've experienced how your mind attempts to trick you into retaining a deteriorating stock because selling and acknowledging the loss (formerly only on paper) is emotionally distressing.

NEVER Leave a Stop Loss Order with a Broker

To address the subscriber’s query.

We strongly advise against entrusting a stop loss order with a broker.

You never know what could transpire, and daily price gyrations can be erratic. Take a look at this flash crash elucidation on Wikipedia to comprehend the extent of this volatility – what is a flash crash.

This implies that if you leave a stop loss order with your broker, there's a good chance it may be executed even though the closing price isn't substantially different from the previous day.

For these reasons and to minimize trading costs, in the newsletter, we only assess whether the 20% trailing stop loss has been breached once a month – on the day the newsletter is distributed. I suggest you do likewise or adopt a similar approach.

Remember to factor in dividends in your stop loss computation

As mentioned previously, remember to account for dividends when evaluating your stop loss levels. This is especially critical for companies with a high dividend yield.

When a company goes ex-dividend (trades without the dividend), its stock price typically declines by the amount of the dividend. For instance, if you own a company trading at $1.00 and it pays a 10% or $0.10 dividend, it implies the stock price will depreciate by 10%.

Therefore, if the company was already hovering at a 10% trailing stop loss, and it tumbles an additional 10%, it may reach your 20% trailing stop loss level.

However, this is misleading because the dividend is usually disbursed a month or so after the ex-dividend date. Consequently, you must factor in the dividend (yet to be received) when computing the stop loss level.

Here's the formula: (Current stock price – the highest stock price + the dividend per share) / the highest stock price.  In essence, you add the forthcoming dividend to the decline of the stock price from its all-time high.