Stop losses useful only when... - The Daily Reckoning
The Daily Reckoning by Bill Bonner
On This Day - 20 January 2015
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Stop losses useful only when... A  A  A

- By Bill Bonner

Bill Bonner
Rancho Santana, Nicaragua

Dear Diary,

Markets were closed in the US yesterday. So, today, we really are going to talk about trading stops. Mathematician Dr. Richard Smith was kind enough to come to visit us in Nicaragua and allow us to buy him a drink or two. He explained how they worked. And he told us about how he's made them work even better.

"The world is much more uncertain than people think," began the man with a Ph.D. on the subject. "There are always far more potential outcomes than you can imagine. So, you're going to be wrong about the future more often than you will be right."

We have demonstrated that often enough ourselves. We needed no more proof. But Richard wouldn't let up:

"Just look at the price of oil. There must be 1,000 analysts and economists following the price of oil. Do you remember a single one forecasting $40 oil?"

Richard began investing when he was working on his Ph.D. He figured he'd be good at it, since he had such a firm grip on the numbers.

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"It was a disaster," he reports. "I began at the top of the dot.com bubble. I lost everything."

It was later that he discovered trailing stops.

"Porter Stansberry uses simple 25% trailing stops. I started following Porter's recommendations without using the stops. I noticed that he got a 79% return from these recommendations. I actually lost money on them, because I wasn't using a trailing stop."

This prompted a considerable effort of reflection and meditation. Richard tested and back-tested. He proved that trailing stops really do work. Then he developed his own proprietary improvements - his 'smart stops' - that boost the performance of a portfolio by matching the stop to the volatility.

"There's always noise in the market," he says. You don't want the noise to take you out of a good position. And you don't want to stay in because the noise covered up a genuine sell signal.

But let's back up. What's a trailing stop? It's just a protocol that tells you to sell your stock if it falls a pre-determined amount. A stop loss of 25% is common. That means, you're willing to suffer a 25% loss before you get out.

That's how you protect yourself from larger losses.

But wait. Do you also guarantee a 25% loss? If you have an automatic or semi-automatic stop loss system aren't you committing yourself to sell your positions when they are down? All stocks go up and down. Sooner or later, your stop loss will be hit. Why would you want to sell your stocks when they are down? Wouldn't it be better to sell them when they are up?

Oh, dear reader, these are good questions. We have posed them many times. And every time, our answer was:

Stop losses are a bad idea.

In our opinion, (revised only recently) if you are using a trailing stop you are not investing correctly. As we have seen, an investment is a good one if the stream of income it brings is worth more than the price you paid for it. So, an automatic or semi-automatic sell system is completely irrelevant. What difference does it make if the price of the stock goes down? None.

Putting it another way, suppose you find a good stock at a good price. You buy. Now, imagine that the stock goes down in price. What should you do?

Check your math. And buy more!

If you are a serious, long-term value investor trailing stops are meaningless. Or worse, they force you out of good positions just when they've gotten even better. Richard proved this too. He ran a test of Warren Buffett's portfolio. Guess what? It didn't work as well with trailing stops.

"Buffett is under no pressure," Richard explained. "He knows the companies he buys. He knows their cash-flow and sales figures - often better than management. He knows the people running the companies. He won't be panicked out of good positions in bad markets. In fact, he'll use downturns as opportunities to get more of what he wants at better prices.

"Most investors - 99% of them - are not like Buffett. They don't have the time, the money, or the knowledge he has. They need tools to help them avoid big losses and take advantage of big gains."

So, if you are like Warren Buffett, forget the trailing stops. But if you're like the other 99.9% of investors, they can help. Tomorrow, more on how you use trailing stops to more than double your returns on the same investment positions.

Bill Bonner is the President & Founder of Agora Inc, an international publisher of financial and special interest books and newsletters.

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The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and have not been authenticated by any statutory authority. The author and Equitymaster do not claim it to be accurate nor accept any responsibility for the same. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. Please read the detailed Terms of Use of the web site.

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1 Responses to "Stop losses useful only when..."

S R ACHARYYA

Jan 22, 2015

'...forget trailing stops' is a sound advice to the investors unless they do only day-trading.

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