Markets were closed in the US yesterday for Martin Luther King Jr. Day.
So, today, we really are going to talk about stop losses.
Mathematician Dr Richard Smith, who runs TradeStops.com, was kind enough 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. in 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 thousands of 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.
‘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.
Basically, a trailing stop kicks you out of a position at a preset percentage below its highest closing price.
‘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 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. And he proved that trailing stops 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 that ‘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.’
If you have an automatic stop-loss system, aren’t you committing yourself to sell your positions when they are down?
Isn’t that the opposite of ‘buying low and selling high’?
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 investing incorrectly.
As we have seen, an investment is a good one if the present value of the stream of income it brings in is worth more than the price you paid for it.
So, a stop-loss system is completely irrelevant. What difference does it make if the price of the stock goes down?
None. (For this reason we don’t recommend trailing stops for the long-term family wealth investors who are members of Bonner & Partners Family Office.)
Put 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!
Are you as smart as Warren Buffett
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.
For The Daily Reckoning