Measuring the Benefits of Disciplined Trading

The following post was written and/or published as a collaboration between Benzinga’s in-house sponsored content team and a financial partner of Benzinga.

Veterans of investing will tell you to cut your losses when a stock turns out to be a poor bet. They will also tell you to take your profits when a security does extraordinarily well, if only to reinvest when the security retreats back to a reasonable valuation. This article focuses on the first question—when to cut your losses.

The Premise

A savvy investor invests in a stock if her analysis reveals that the underlying company is sound, and there is potential for improvement. Perhaps the company has a solid balance sheet and strong net income, and relative to its assets, liabilities and net income, the company’s stock price is on par with its competitors or even cheaper. But sometimes, a savvy investor invests in a company, but the company’s stock price begins to fall and keeps falling.

The reasons for the fall in stock price could be myriad. The company could have lost business to a competitor, or it could have invested in research and development that flopped. It could have begun taking on too much debt to grow aggressively. Whatever the reason, the investor now faces a tough decision: should she stay with the stock, or should she cut her losses and sell at a loss to preserve her remaining capital?

This article explains the effects of cutting one’s losses with discipline over time in the context of a real portfolio. In particular, we will focus on the effects of cutting one’s losses if the fundamental aspects of a company sour. (A future article will explore the effects of cutting one’s losses if the fundamentals of a company remain good, but the stock continues to fall for whatever other reason, such as a broad market selloff, a change in investor expectations, etc.)

To keep our analysis simple, we will be examining these effects while using an investment strategy of selling stocks according to just one basic “technical analysis” rule for profit-taking: whether the stocks have an RSI Index value greater than 90 (values range from 0-100). RSI Index values greater than 90 represent an “overbought” security.

Disciplined Unwind If the Fundamental Factors Worsen

To see the effect of systematically cutting losses when a company’s fundamentals decline, we can compare two backtests, one with a loss-cutting strategy and one without. A backtest is simply the application of historical data to an investment strategy to simulate its performance over a specific timeframe. For this article, we will compare the results of a simple investment strategy (our “control” strategy) with the results of the same simple investment strategy but implemented with a disciplined unwind of a stock if the company’s fundamental factors worsen (our “disciplined” strategy). We used our web-app to run the backtests and conduct our analysis.

We can implement our control and disciplined strategies by starting with a basic large-cap template. To encode our control strategy, we modify the template to include exactly two types of actions. Our first action will simulate the savvy investor’s buy-analysis: we tell the strategy to buy any stocks that satisfy a battery of metrics. Our second action will implement our simple profit-taking strategy by selling any stock whose RSI exceeds 90. To keep things simple, we will limit our portfolio to 25 stocks, with each stock not to exceed five percent of the portfolio. We will also limit ourselves to stocks denominated in USD.

To encode our disciplined strategy, we simply duplicate our control strategy and add a third action to implement our loss-cutting strategy: we tell the strategy to sell anything in the investment portfolio that fails to satisfy those same metrics after being purchased.

Now armed with our basic control and disciplined strategies, we can compare their backtest results. We will look at these comparative backtest results with both “Value” buy metrics and “Growth” buy metrics.

Value-Strategy Large-Cap

Here are the results of the strategy with a disciplined unwind of a stock if its fundamental factors worsen (the disciplined strategy), side by side with the results of the strategy with no loss-cutting strategy even if the fundamental factors of the stock change (the control strategy). Here, both strategies use value metrics to determine which stock to buy.

Even though at the end of 15 years their returns are close, the disciplined strategy that sells stocks when their companies’ fundamental data deteriorate is much steadier and ultimately better. This “steadiness” is termed volatility, which is measured as a percentage of the portfolio’s value itself. The control strategy, which doesn’t have this feature, is choppier, especially around the financial crisis years of ’08-’11, and the market shock in early 2020. The key here is the performance ratio, the amount of return per percentage-point of risk. The 0.46 performance ratio of the disciplined strategy is 1.23x higher than the 0.37 performance ratio of the control strategy—a 23% improvement! For investment professionals, this improvement is dramatic, as it is achieved over a 15-year horizon. Another way to think about this is, if you took the same amount of risk in the Disciplined strategy, your returns would be 23% higher, so your return per year would be 3.36%, which is higher than the Control strategy’s 3.08%.

Growth-Strategy Large-cap

Here, the difference is even more dramatic. The disciplined strategy has a higher return, and it is less volatile. The control strategy suffered worse in the financial crisis of ’08-’11, and in 2020, the control strategy did so poorly it never recovered. The performance ratio of the disciplined strategy (0.18) is 50% better than the control’s (0.12)!

Final Thoughts

Although these results are striking, we must be careful about the kind of general conclusions we can draw from them. We have only examined results from value and growth strategies over a single historical period. Had we selected stocks using different criteria, run our strategies over a different time frame, changed our portfolio size, been more restrictive with loss-cutting strategies, etc., we would have arrived at different results. Many academic papers examine these and other scenarios, with many papers also publishing the results of monte-carlo simulations that run thousands of randomly generated scenarios in an effort to identify optimal strategies. Although an examination of those scenarios falls beyond the scope of this article, this article has illustrated the effects of adding a disciplined approach to investing, making it easier to understand and internalize why professionals make decisions that retail mom-and-pop investors often avoid.

Sometimes, investors are still in favor of strategies that suffer huge losses historically because the final portfolio value may sometimes end up higher than the results of a disciplined approach, volatility-be-damned. Investors have to ask themselves, however, if they would truly have held onto their losing investments during periods of financial strife without knowing the future. Only those of us who invested during the last 15 years and stared at the financial abyss multiple times will know the answer.

Of course, a single historical path is not a crystal ball into the future. Nevertheless, a quick backtest can provide insight into the strengths and weaknesses of a trading strategy when credit collapses, housing prices crumble, and loans become impossible to obtain (’08), when interest rates plummet to zero (’11-’18), and when volatility skyrockets and liquidity disappears (’19-’20).

Preparation is the key to investing and understanding a portfolio’s strengths and weaknesses is central to that preparation.

The preceding post was written and/or published as a collaboration between Benzinga’s in-house sponsored content team and a financial partner of Benzinga. Although the piece is not and should not be construed as editorial content, the sponsored content team works to ensure that any and all information contained within is true and accurate to the best of their knowledge and research. This content is for informational purposes only and not intended to be investing advice.

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