One of the Few, True Secrets of Successful Speculation

Editor's note: Chances are, you're taking dangerous risks with your portfolio today.

But one simple risk-management strategy can dramatically lower your risk... without lowering your upside.

In today's Masters Series essay – excerpted and updated from a January 2011 Digest – Porter explains the power behind trailing stops... and shows a real-life example of how much it can affect your results in the market...

One of the Few, True Secrets of Successful Speculation
By Porter Stansberry

Today, I (Porter) would like to review the idea of trailing stop losses. Now, you say, "I've been using this strategy for years. I already know everything about it." You might think that's true... But in my experience, even sophisticated and experienced investors have a hard time using trailing stop losses accurately. It can be both emotionally challenging and technically difficult to cut your losses. I have two solutions to share with you today. (Don't worry... If you've never heard of stop losses before, I'll explain them thoroughly.)

More important... I commissioned (at considerable expense) a thorough study on the subject. You see, a fundamental debate is ongoing about using stop losses all together. Many smart and talented advisers regularly criticize our stop-loss strategies – sometimes with great passion. But they cite only anecdotal evidence. In the past, we've responded with some statistical proof... but nothing bulletproof. I've often wondered if our preference for limiting risk was as effective as we believed. And so I decided to settle the matter once and for all...

I hired one of the world's best statistical analysts to analyze the track record of our best fundamental advisory, Extreme Value. The purpose of the analysis was to answer this question: Does the use of trailing stop losses improve investment performance?

You'll get the whole story below...

But before we get to the detailed analysis... some new readers probably don't know exactly what a trailing stop loss is or how to use it appropriately. What the heck is a trailing stop loss? A stop loss is the price at which you will sell a stock, no matter what else is going on in the market. If you buy a stock at $10 and decide to strictly limit your risk to 25% of your investment, you will sell that stock if it trades for less than $7.50. Selling is the only way to guarantee your loss won't grow. Critics of this approach argue it's illogical to decide (in advance) to sell only when doing so ensures a loss.

A trailing stop loss takes on this criticism by increasing your automatic sell point if the stock moves higher. So if you buy the stock at $10, your initial 25% trailing stop would be set at $7.50. But if the stock eventually traded as high as $15 a share, you would move your stop to $11.25. This way, you're not necessarily going to take a loss at all... even if you're forced to exit the position because of your stop. Your stop loss point is said to "trail" the stock price higher, which is why it's called a "trailing stop loss."

Steve Sjuggerud was one of the real pioneers of this technique. He used this approach during his time as a broker – mostly to keep clients from continuing to dump money into losing positions. Van Tharp is another pioneer of the strategy. He profiled it in his extremely profitable book, Trade Your Way to Financial Freedom.

When I began working with Steve more than 15 years ago, few individual investors used stops of any kind. Brokerage firms didn't offer them much in the way of support. Today, most individual investors understand trailing stops and most brokerage firms offer the ability to use them on their electronic platforms. But we strongly recommend you should ALWAYS keep your trailing stop loss levels completely private and never share them with your broker.

Why? Because many times your broker will enter your stop loss in the market on a good-til-canceled basis. That means other traders can see where your stop is set. If the market gets close to that point and lots of investors have set stops at about the same price, the market makers will move the market to trigger those stops, knowing once the selling is done, the price will quickly rebound. We have seen the market makers do this to many of our recommendations over the years. Never enter your stops with your broker. NEVER.

But how are you supposed to follow your stops if your broker doesn't monitor your positions for you? Well, one easy way is to use TradeStops. This website allows you to enter your stocks and set a percentage stop loss. The website will notify you – privately – if your stock has been stopped out, allowing you to exit the position.

The website is the brainchild of Dr. Richard Smith – a longtime subscriber and a good friend to our business. Dr. Smith has a PhD in systems analysis. He is one of the smartest and most talented people we know. He regularly helps us when we need advanced computer programming or intense statistical analysis – like when we were building our True Wealth Systems models. I don't get paid a penny for saying this. I simply know it's true: If you use TradeStops, you will make more money with your investments.

How do I know it's true? How can I really know that using trailing stop losses will improve your investment performance?

First, it's logical. Using a stop loss will not optimize any individual position. It will not help you buy at the bottom or sell at the top. (Of course, nothing but experience and knowledge can help you with this goal. There's no shortcut.) But using stop losses does allow you to systematically structure the risk you're willing to accept. And by limiting your risk, you will certainly improve the overall performance of your portfolio. Why? Because using stop losses completely prevents the catastrophic losses that end up destroying your portfolio's long-term performance.

I've seen lots of newsletter writers do a good job for their readers... until they pick the wrong stock at the wrong time and it blows up. It goes to zero... or nearly zero. They suffer a 90% loss. That one loss ends up wiping out dozens of successful investments. And I know this happens, time after time, to individual investors. Using stops on all your positions will make this impossible. And your results will greatly improve.

Most people can grasp this concept. And most people realize the strategy makes sense based on their investing histories. But... most people have a difficult time following the strategy and making it an automatic part of their investing. Instead, they put a "mental" stop on their positions. When it is triggered... they do nothing.

They convince themselves not to sell yet... that the stock will soon bounce back. They wait. And wait. And pretty soon they're down 90% on a stock and right back to where they started.

I commissioned Dr. Richard Smith to look at every recommendation published in Extreme Value since its inception in 2002. This 15-year track record gave us a valuable and unique laboratory in which to test our hypothesis that using trailing stop losses greatly increases investment performance.

Why? Two reasons. First, Dan Ferris rarely uses trailing stop losses in Extreme Value (except with shorts). Dan firmly believes the best approach to risk management is to always buy good companies at a low enough price to ensure a "margin of safety." Using this record, we can go back and see if an investor, had he used trailing stop losses, would have made more money than simply following Dan's advice on when to sell.

The other consideration is the quality of the letter. Maybe stop losses do work when you're using a lousy investor's recommendations, but what if you're following a great investor like Dan? We charge $1,000 a year for Extreme Value. It's widely read by the world's best hedge funds. It's highly respected on Wall Street because of its unique focus on value, safety, and quality. It has a great track record. Trailing stops should not be effective in this portfolio.

What did Richard find? Over that 15-year period, we recommended 116 separate equities in Extreme Value. Keep in mind... a handful of these positions were short-sell recommendations. The average gain across every recommendation made from 2002 through the end of 2016 was 30.3%. That's a terrific result given the dominant market movement in the period was the terrible bear market of 2008. The average duration of these investments was 775 days. This implies an average annual return of 9.8%. We are extremely proud of these results, which outclass just about any equity mutual fund, and we know how hard Dan worked to achieve them...

But we always strive for better results. Always. Is using trailing stop losses a simple, mechanical way to improve our performance?

The answer is undeniable: YES. Richard put Dan's performance data into a statistical database that allows us to compare the results of using trailing stops at various levels. In this way, we could discover if using "tight" trailing stops (say, 10% or 12%) worked better than using loose trailing stops (say, 30% or 50%). Here's what we found...

Using tight trailing stop losses greatly reduced performance, in almost a uniform way. The average profit of all the trailing stops at or below 25% reduced performance. The greatest reductions occurred at the lowest stop levels. If your stops are too tight, you will do worse than not using any stops at all.

Using trailing stops of 26% or higher increased performance, almost uniformly, all the way up to a trailing-stop level of 44%. That is, using trailing stops at any level between 26% and 44% increased performance, with the best performance coming at the highest level.

The average gain using a trailing stop at 44% was 66.7%. The average duration was 922 days. The average annual result of this portfolio would have been 18%, or nearly two times the actual performance of Extreme Value. This represents a large and statistically meaningful increase in performance. There's almost no way this difference is merely chance.

Performance begins to decline when using trailing stops larger than 44%. The duration of the investments is increasing while the average gain is decreasing.

These results suggest the most effective trailing-stop level for Extreme Value is somewhere between 26% and 44%. Using trailing stops at these levels doubled the average returns of Dan's letter, while reducing the average time period by roughly two times.

Looking at these results, I want to reiterate in the strongest possible terms that you should be using some level of trailing stop losses.

Regards,

Porter Stansberry

Editor's note: At some point soon, this historic bull market will end and stocks will crash. It could happen tomorrow, next month, or even next year. That's why, on Wednesday night, Porter, Richard, and Steve Sjuggerud are hosting a free event called "The Day the Bull Market Will End," where they will show viewers EXACTLY when to sell your positions... how to use Richard's software to drastically improve your returns... what to do with your money right now... and much, much more. Save your seat right here.