Stop Losses may not work
STOP LOSSES – THEORY VERSUS REALITY
Member email: Some gurus tell me that when I buy a stock (even for the medium to long term) I need to set a stop loss, in fact at the point of purchase it needs to be already set. How does that sit with these very small, speculative stocks. Do you have a stop loss or a set of criteria in mind for when you would get out?
Reply: I can explain stop losses, how to set them and why you should use them. And yes, if you follow the textbook you will be told that for every trade (note, trade, not investment) you should have a trading plan decided upon before you buy, and that you need to stick to rigidly, because your rather pathetic human nature is rubbish when it comes to selling things. Great theory, but let me tell you about the reality of stop losses.
We have been using stop losses in the TRADING PORTFOLIO for over a year and have advocated stop loss strategies in the newsletter for decades. They are so logical. But the reality is not so perfect because they trap you into being short term.
The reason you come to the stock market is not to get an average return, you can get that anywhere these days - in a managed fund, a listed investment company, an ETF, an SMA. Lots of places, and you can achieve those average returns with just one ASX trade. So why would you bother building a 20 stock portfolio. Why would you bother with diversification. It’s for the sheep, and, if you believe some recent managed fund marketing (which I loved), sheep are for slaughter and you can follow the herd or hunt it. Along those lines here are some of images from the Fat Prophets Global Contrarian Fund Prospectus which I thought was great for its unconventional marketing lines:
So the reason you come to the stock market as an individual is not to get an average return, is not to exploit all those motherhood statements about compounding returns, expounded in sycophantic Buffett centric books, you come to the stock market as an individual, to accelerate your returns, to earn more than the average, otherwise what’s the point in wasting all that time doing something a fund manager can do for you for 2%, with your only responsibility being to open one letter once a year and find out how they did for you.
You come to the stock market to trade individual shares as an individual either because you are behind the eight ball on where you would like to be financially, and you want to improve the situation, or because you enjoy it. That’s why you’re here. The stock market offers the opportunity to improve your financial situation in a way that almost no other asset class can. That’s the drawcard.
But after many many years of trying to beat the average return there is one thing that has become obvious to me - you cannot win in the stock market in the long-term if you play the short term.
Read any book from a professional trader, Market Wizards is a good condensation of the thoughts of many traders, and the same message will come through. Ambitious traders almost without exception start out using second, minute or hourly charts, chasing large gains in the short term. But after they are pummelled relentlessly for their short-term focus they all move up the timeframe curve to daily, weekly and monthly charts. The short-term is random and there is no edge for the mortal man.
But, somewhere along the timeline curve, as you raise your gaze from the navel to the horizon, somewhere in the middle there, there is an edge. The edge is in identifying, in the equity market, quality stocks in the medium and long-term. This should be your focus. It is certainly mine. Identifying companies with positive medium and long-term drivers and taking them for a ride.
Back to stop losses - Stop loss strategies are great for controlling mistakes (limiting losses) but, as we have found out in the TRADING PORTFOLIO, they have one unfortunate side-effect. Unless you set them wide, stop-losses trap you into being short term. As such they exclude you from the one thing that pays off…investing in medium and long-term growth stocks. Yes they are great for traders, yes there are a lot of very logical reasons to use them. But unless you widen them significantly they trap you into being short term because in the life of even a quality stock, you will always get stopped out one day. There will be one day of volatility that will trigger your stop loss.
And in so doing, it will cut you out of the one thing that pays off, making money in quality stocks over the medium and long-term.
STOP LOSSES FOR INVESTORS
The good news is that stop losses still work for investors but to make them work requires a less mechanical set-up and a higher tolerance to ‘drawdowns' (losses). You have to be rich as well, because if you can't ride a paper loss without twitching, you'll never make money investing in a stock price that moves daily.
Next year I will be running intimate 14 people workshops called “STOCK PICKING FOR THE ACTIVE INVESTOR with Marcus Padley” – they will be for Members only and will teach you everything I know about stock picking in an intimate environment (our boardroom in Melbourne – somewhere else interstate), which will include stop losses in the content. I will put the dates up this week. They will cost $750 for the day including lunch, some freebies and a drink afterward.