PROFIT is a major driver for entrepreneurs, traders and investors. Entrepreneurs earn when revenues are higher than expenses. Traders gain when securities are sold at a higher price. Investors aim to get a positive return over time.
One cannot travel the road to profitability without acknowledging its headwinds and roadblocks otherwise known as risks. When risks try to spook us entrepreneurs and traders, how low are we willing to go?
My sister bought a pharmacy franchise in 2018. All in all, she had invested P800,000 for this business. Though the rent expense was minimal, much of her capital was for inventory and for the salary of a licensed pharmacist. To be sustainable, the projection was for the pharmacy to earn at least P1,000 per day. Because the pharmacy was new in the area, income for the first few months was good. Half a year later, things started to change. In most days, the quota was no longer met.
More cash was injected to keep the business afloat. The pharmacy continued for three more months until, eventually, the net negative cash flow was too much and the business closed.
A “Stop-Loss” strategy could have mitigated such loss. The Investopedia website describes this as a strategy to limit potential losses if the price moves against the intended strategy. Much like signposts that warn us to slow down or take a detour, this notifies us to exit our position on a security or in our interests on a business.
While the concept of stop-loss applies to all, its execution varies for each person. Each of us has a different risk-reward tolerance. If you want to earn more, you need to risk more. Some people can take a high degree of risk; some could not. A risk profile questionnaire can give us an idea of our risk appetite. We can either be conservative, moderate or aggressive. We would never know unless we take this test.
Next is to quantify your stop-loss. This can be 5 percent, 10 percent or 20 percent of your investment, depending on your risk tolerance. The more aggressive you are, the more open you are to potential losses. Note that a 5 percent stop loss is relative to the principal amount. The margin for potential loss is smaller for a P100,000 investment versus a P1-million investment.
Another factor to consider is volatility. Forex, cryptocurrency and certain commodities are more volatile than stocks. As an effect of volatility, prices fluctuate more and, thus, a sudden steep drop may trigger your stop loss faster.
Years ago, hype caused me to buy a certain IPO with the objective of selling it when the price appreciates. Having excess cash at the time made me execute this at a heartbeat. Without a definite stop-loss strategy, I lost nearly half of my money. I did not know what to do with the other half I was able to pull out. After executing a stop loss, have a contingency plan.
For traders, you may want to buy shares of a company in another sector or another country. For conservative entrepreneurs, you may want to park your cash in a digital bank or money market fund as you revise your business strategy or ponder on your next venture.
Creditors can also benefit from having a stop-loss strategy. While it is true that creditors can increase the risk premium when the repayment period is longer and the loanable amount is bigger, there is not much to do when the debtor defaults. Recall when friends or relatives borrow cash from you. Should you find merit on their request, you lend them money. In some instance, the same person borrows again, even if the first loan is not yet fully paid. As a close friend or relative, how can you turn them down?
Many creditors find it hard to quantify how much is enough. Financial planners say that a creditor must only lend money he or she can afford to lose. Check excess cash that you can afford to lend, but do not exhaust all of it. The loanable amount must not trigger your stop-loss amount. Should the same or another person attempts to borrow from you, deny the request as your stop loss has already been reached.
Maximize your profits and minimize losses—that is the end goal. A stop-loss strategy is a helpful tool to achieve this. Let’s go for stop loss.
Marion Evangelista, RFP CTEP CTA is a registered financial planner of RFP Philippines. To learn more about personal-financial planning, attend the 97th RFP program in August 2022. To inquire, e-mail info@rfp.ph or text at 0917-6248110.