Why do you need stop losses?
Basically because after decades of being told to set and forget most investors are bloody useless at selling and stop losses provide a robotic mechanism to replace your otherwise indecisive nature.
Selling is one of the most important skills of any investor. Most traders have it down pat because they do it so often, but one of the major failings of investors is that when one or all (as in the GFC) of their stocks falls they just do nothing and hide in motherhood statements promoted by Warren Buffett sycophants which elevate long-term investment to the moral high ground. Well the GFC changed all that.
I was working for a Japanese broking house in London in 1987 when the stockmarket collapsed. The principal trading book (the broker’s own money traded in the markets by a team of professional traders) started bleeding as the traders responsible tried to trade themselves out of loss-making positions and did, even more, damage in the process. After a few months, the head of the trading desk told them to close out everything even if it was in a loss. Having done that he then sent four traders on holiday for a month. To stop them trading. He told them to go and play golf. They did. These moves saved the firm a fortune.
Walking away from a loss-making trade is very hard to do, but hanging on in hope is perhaps the biggest sin of all. So why is it so hard to take a loss?
One academic study into behavioural finance once put up a theory that, true or not, makes a convincing stab at explaining it. The theory goes that losses have three times the emotional impact of a gain. We react more emotionally to losing money than making it. It is why markets fall three times faster than they rise. Because fear is a more powerful trigger for action than greed. When it comes to selling, it’s the quick or the dead. When it comes to buying, you can take your time.
Losses create emotion and emotion is a problem for all private investors. When you are physically sweating at your loss, when you are concerned that this one is so big you can’t tell your spouse, are you in any fit state to be making a rational decision? No. So you need rules and mechanisms to eliminate the confusion and to make the decision for you. To do what we are all so bad at. Taking a loss.
Brokers live through this “shall I take the loss?” debate with their clients every day, so we have developed arguments to persuade our clients to do the sensible thing. So if ever you are having trouble taking a loss, if ever you are not enjoying your trading, are getting emotional and the stock is still in your possession, read this list. You will have put on a ‘sell’ order before you get to the end.
- If a stock is going down, it is far more likely to continue going down than it is to turn on a sixpence to suit your wishes.
- The further a stock falls the more intense the selling becomes as higher losses cause more selling decisions. So sell early. An early loss is the smallest loss.
- If you sell 10 falling stocks, as any technical trader will tell you, it will be the right thing to do in 9 cases – but you will only remember the tenth.
- If you sell now, you are no longer exposed. All you have to do is come to terms with the loss.
- If you sell now, you can always buy back the stock. And who knows, you might buy it back lower than you sold it.
- If you sell now, you enter the eye of the storm. All becomes calm. You can watch from a distance and have a moment to think. You can always choose to enter the storm again, and if you do, you will be thinking more clearly and be armed with a plan.
- If you are making a loss on a stock, think to yourself: if I had cash would I buy this stock now at this price? No? Then why are you holding it? Sell it. (Most people begin to ‘hate’ the stocks they lose money in, so this argument always works).
- Your state of mind has a value. What would your spouse pay (or you pay) to have you carefree at the weekend instead of ripping the heads off the kids? Look after yourself. There are not that many weekends in the year or your life. Don’t ruin too many of them by keeping risky loss-making positions until Monday because you didn’t have the guts to sell them on Friday.
- Averaging down is what brokers advise you to do to distract you from the fact that they have put you in something that has lost you money. Do you really want to turn a short-term trade into a long-term loss? Every day you see it in your portfolio. Every day it will be flashing “You idiot.” There is a value in avoiding that.
- Averaging down is a mug’s game. If you have money to invest, you should be putting it in the best investment in the whole world. Do you really think that that is going to be the very same stock you have already bought at a higher price and that is falling at the moment? Very, very unlikely. You already have an exposure as well. Why do you need more of something that has already proved itself to be a dog?
- The quickest way to become a long-term investor is to make a short-term trade and get it wrong.
- There is no logic in being emotional about losses. Do what most brokers do with their own shareholdings. They have an Excel spreadsheet linked to live prices monitoring all their holdings and what they are worth. At the bottom of the page is a total of what all the holdings are worth now. That clicks over every second all day. Up $500 down $500. This figure is the only truth. This is what the shares are worth. What you paid for the shares is irrelevant. So why care about whether the bottom line is a profit or a loss. It is an amount of money. If it’s gone, it’s gone….period. It is no more likely to come back because you paid a higher price. (There are still clients who will tell you they have $50,000 in ABC when the holding is worth $25,000. You do not have $50,000 in ABC, you have $25,000).
- Most clients who have loss-making stocks will tell you that they “hate XYZ.” So why hold it? Far better to put the cash in something that you want to wake up to in the morning than something that depresses you.
- If in doubt, sell.
You will find that loss-taking is a rather cleansing experience. In the next lessons we will look at the mechanics of a stop loss.