The Investment Scientist

How to Set Effective Stops?

Posted on: June 24, 2007

The title is a question posted to me, the following is my answer.

I don’t use stops, there is not any evidence that there are effective stops. (By evidence I mean rigorous and peer reviewed academic research.) To protect against downside risks, I use an “ex ante stop”. OK, this is a term I make up on the fly. What I mean is that I only invest in stocks with P/B less than 1.3 where P is the market value of the stock and B is the book or accounting value of the stock. Presumably, the market value of a stock can not fall below its book value in equilibrium. (It does not work that way all the times, but it works most of the time.) By investing in these type of stocks, I limit my potential losses to less than 25%. Comparatively, S&P 500 stocks have an average P/B of 4.7, which means the average stock price needs to fall over 75% before reaching the average book value. Nasdaq stocks have an even higher average P/B of 8.6. In summary, investing in low P/B stocks is a much more effect way (with a mountain of academic research to back up) to limit downside risks.

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Author

Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC. He is also a regular contributor to Morningstar Advisor and Physicians Practice. To explore a long-term wealth advisory relationship, schedule a discovery meeting (phone call) with him.



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