The idea of “Cut Loss” comes from trading stock. Cut loss strategy is useful and necessary in stock trading because there are a lot of unknowns and uncertainties in the stock market. Without using cut loss strategy, a trader will risk himself losing all of his capital. This happens most of the time to novice traders and investors. Capital bleeds to dead (dry up) at the end. Cut loss means willing to admit with boldness that you are wrong and accept the loss, exit the trade entirely in order to stop the bleeding of your capital asset.
This strategy apply to stock traders and some investors prudently. But does this apply to Unit Trust investment since there are professional hired to monitor our invested fund?
To make this question more complicated, we have to realize that there are even investors do not agree on cut loss strategy too. This group comes partly from value investors especially. They think that cut loss is not necessary when they see prices of their invested stock drops. They would normally advocate using “Top Down” (buy even more) strategy instead. When prices drop, it will be cheaper to buy, therefore value investors would see golden opportunity to buy even more.
Top Down instead of Cut Loss
However this “Top Down” strategy has its limitation. For one, it is opportune limit. Secondly, it is the limit of your available capital. Top down strategy would be useful at the beginning of the trade. When the value of the initial investment has turned into losses at the beginning stage, every additional purchase would average down its entry price value effectively.
However, this average down effectiveness will also be hampered or inhibited when the total value of the investment becomes larger (because of subsequent “top downs’”). It becomes cumbersome or harder to average down the entry price value any further effectively. It will take another total amount of the already enlarged invested sum to make the entry price value average down by 50%.
Therefore, the top down strategy is best used not more than twice in any trade advised by professional traders. After top down purchases have been done twice, if prices are still falling, cut loss is seen as a better alternative, in order to avoid your investment falling deeper into the abyss. Therefore, cut loss strategy still appears at the battle scene.
Does this apply to unit trust investment? Do we need to do cut loss if we see our initial investment falling into losses, particularly when it seems falling into the void? Can we use top down instead of cut loss too?
Unit Trust Investment vs Stock Investment
In order to answer this question, we need to understand the similarities and differences between stock and unit trust or mutual fund investment. Similarities between them are; both of them involves risks, the higher the reward, the higher the risk. They are both revolving around stock market and playing the same zero sum game. For retail investors like us, these two investment vehicles are both having common characteristic in the area of lack of transparency. For the above reasons, cut loss can be considered prudent enough to employ in both investing field.
However, major differences are these; Retail investors in stock markets are usually eaten up by big players. These big players are normally fund managers. Stock investments or trading done by retail investors are lone rangers. As a reason, cut loss is easily seen as mandatory in order to protect capital from unknown causes of investment loss.
Fund Investment Major Characteristic
On the other hand, though fund houses normally come with large capital and invest their capital wide spread among selected stock choices (can be ranging around 40 – 50 stock choices) according to their designated mandates. The purpose of this so called diversify strategy is to mitigate losses due to a few bad stock choices which can normally happen to retail investors with limited capital fund.
However, there is also a double edge sword for diversification strategy. While it can mitigate losses, it also inhibits profit at the same time. (More discussion has already been said in Maximizing Return on Your Investment.) Therefore, movement on either direction for all unit trust prices can be slow and lethargic.
Even then, no fund house or fund manager can avoid any down fall caused by macro development of any economy. One thing for sure, if any macro economy going down, fund manager can only lessen their investment exposure but cannot withdraw totally from the market because of the duty entrusted to them as spelled out in their prospectuses.
Therefore, unit trust retail investors will see their fund prices going down slowly at that time. At this juncture, if the macro economy down trend is confirmed for longer than anyone desires, cut loss of your unit trust will seem to be more prudent than letting your investment going down to the pit.
In another scenario, when you invested your capital into certain fund after much careful study, while there is nothing wrong with the macro economy, but your fund prices happen to be going down without any justifiable neither known reason, you may first give it a benefit of the doubt by top down twice. When you see your fund still sinking, it would take a gigantic faith and risk to continue top down some more, especially when you see other funds are rising but yours is sinking. In this case, would it not be sensible to “cut loss” by switching to the other funds that are rising?
For example, let’s say if someone invested into RHB Gold and General Fund in February 1st 2017 since it was growing (see Graph A).
He expected Gold and General Fund to continue its bullish trend. But somehow, unfortunately it reversed around February 15th 2017. The trend became a down trend until March 1st 2017 and experienced losses. Yet he saw another Fund called Manulife India Fund was rising steadily. Would it not advisable to accept the loss (cut loss) and switch over to Manulife India Fund?
Losing Fund Will Recover Eventually?
While some may argue otherwise, saying that it is not always so lucky to switch over to a better growing fund. There’s still a lot of “what if’s ….” like, what if the new fund repeats the same fake as the previous one? So, they would suggest you don’t have to switch or cut loss, because mutual funds are managed by trusted fund managers and their teams. Fund performances normally would not go down into the stage of “bankruptcy” like any stock counter would. The extent of risk between the two is not equivalent. If you have patient enough, those losing funds would eventually recover, especially if you have chosen a good performing fund.
While this argument may sound correct theoretically, or even professionally, we have to understand the nature of trending pattern. For any stock or fund to reverse its trend, it has to go through 2 different stages. These are Accumulation Stage and Recovery Stage (Graph B).
There would be a possible immediate reversal of any trend right after bottoming. But unfortunately chances are rare. Particularly so when we consider funds invested into a vast range of 40 to 50 stock choices, if it does experience a down turn, that means such drop would be quite severe especially when it is in an odd case scenario. It will take some time for it to stable down preventing further deterioration. The time period of stabilization is called Accumulation Stage before it could move on Recovery Stage.
This period of stabilization or Accumulation Stage, no matter long or short period, to retail unit trust investors, this is the most value draining, time consuming, energy exhausting activity we could ever be involved in. Yes, it is true that such fund would eventually recover, but retail investors have incurred enormous, uncountable losses that we didn’t even realize (while fund managers were still taking their lavish salary and enjoy their lives playing golf regularly). Because price movement of fund is slow and lethargic, you can imagine how long the time spent to wait for it to just recover from the bottom until it breaks even.
For example, if someone has invested into RHB Energy Fund at the end of May 2017 at the value point of 100 (see Graph C). It is true that subsequent losses have already been totally recovered by November 2017 when it returned to the same value point of 100. However, if he would have cut his losses and switched over to RHB Big Cap China Enterprise Fund at any point during the process of his losses, can you see how much difference it would have made at the end of November 2017?
In conclusion, as unit trust investors, we all have to be aware that investing through unit trust, the return is already mild enough and sometimes not even attractive. If you would have spent any time not heaping up profit, your return of investment (ROI) would have even been crippled further.
Therefore for the sake of efficiency and raising the level of the ROI rate, cut loss for any fund in your portfolio that is consistently losing would be a better alternative in my opinion, unless you have a longer life span and extra ordinary patient to wait for your slow growth of unit trust investment to reach the stage financial independence if it ever will do.
Thank you for reading this long article, if you have any different opinion, please feel free to drop your valuable note at the reader’s comment session at the bottom of this page.
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