Within the world of investing there are two schools of thoughts when it comes to stop losses. Many traders, especially ones with shorter term horizons, prefer to use stop losses to control risk. In a liquid stock, commodity or currency, you can control exactly what your downside is controlling risk in each of your positions, as well as for your portfolio at large. Hence your risk of ruin is greatly reduced. There is always the possibility of your holding gapping, but if you trade in liquid markets that risk is minimal. This is also a more common trait of technical traders.

Conversely, many value investors, such as the all mighty Warren Buffet don’t use stop losses at all. Their view is that if a security drops, even by 30% to 40%, it’s simply an opportunity to buy more at a better price lowering their average cost. The theory goes that if you did your analysis of the fundamentals correctly, there’s no reason to react to “Mr Market’s” irrational offers for your holding. Simply wait until the market recognizes the underlying value and “Mr Market” offers you a more rational price.

This is great if your always right in your analysis, the fundamentals are reported properly and somehow not already priced into the market place. But what if, by some miracle, your actually wrong? You could lose 100% of your money waiting for a rational price from Mr Market, when it really turns out your the one being irrational?

Let’s delve into the numbers. Of all the literature I’ve read on the subject (and yes, I have read the Intelligent Investor), the statistics I found most informative were from a fund located in Arizona called Blackstar Funds. They did a research paper titled The Capitalism Distribution, which investigated returns of stocks from 1983 to 2006. Some key stats from this paper:

– 1 out of 5 stocks lost 75% or more of their value.
– 1 out of 5 stocks returned 300% or more of their value.
– 39% of stocks had a negative return over this period.
– 61% of stocks had a positive return over this period.
– Of the 8000 stocks in the study, the best performing 2000 (25% of all stocks) accounted for all the gains, and the worst performing 6000 (75% of stocks) collectively had returns of 0%.

The stat I find most startling, is if you had somehow managed to miss any of the top 25% stocks from 1983 to 2006, you would have made a return of 0%! Ponder the fact that if you were not properly diversified, concentrated into stocks that you “knew” were going to go up, and sat around waiting for “Mr Market” to eventually come around and see things your way, there’s a 1 in 5 chance you’ll lose 75% of your money and its very probable that you’ll make nothing at all.

Suppose you were in the unfortunate situation above and had managed to miss the top 25% of gainers in the market in this period. Let’s say rather than being convinced that your analysis was infallible, you considered the possibility that you were flat out wrong and set a few top losses. We’ll make them relatively wide, since you are a very confident individual as you have the fortitude to invest in the first place, so for arguments sake we’ll put them at 10%. A few of your stocks hit your stop losses, and although you have to realize a loss (which is very difficult physiologically to do, it has been proven that it’s much easier to keep your loss a “paper loss”, a subject for another blog post), you now have the opportunity to hit the books again, do your research and delve back into the market with another opportunity to find that 25% of winners.

Following this strategy you’ve managed to control your risk and rather than have your capital sit around waiting for something to happen in a loser, you’re out finding other winners minimizing your opportunity costs.

The flip side to this its what’s known as a whipsaw, which is the case where you set your stop losses to 10%, the stock dips to 11% then pops up 25% and you miss the move and consequently swear off stop losses for life. For one, this will happen, if you don’t want it too, stop trading. Two, this in my opinion is not an argument against stop losses, but rather an argument against poorly setting stop losses. If done correctly, this strategy will save you a lot more money that it will cost you. In later posts, I’ll share strategy’s that I’ve used for stop losses, such as volatility stop losses, as well as support/resistant level and others.

In conclusion, why do I use stop losses? Because I don’t want myself or my clients to have a 75% loser in our portfolio’s. And although I’m unbelievably intelligent, I’ve astounded myself to occasionally being wrong, and I’m not about to get into a long, drawn out argument with “Mr Market”.

“We must all suffer one of two things: The pain of discipline or the pain of regret and disappointment.”