Every now and then, I’ll see another investor mention stop losses, and how they use them as part of their exit strategy. While on the face of it, these automatic selling mechanisms seem to make a lot of sense, they leave a lot to be desired both philosophically and practically.
I won’t mince my words:
stop losses are for speculators, not investors
To clear up any semantic ambiguities, investors look at businesses, estimate their value, and then try to buy below that value and sell above it. Speculators look at the market and use the market itself as the primary means of determining value.
For example, a speculator looks at a stock that has been moving up in the past few weeks and decides that the market is saying this is a good investment. It must be, the speculator surmises, because other people are buying and pushing the share price up.
An investor, on the other hand, would pay no attention to the historic share price action. Instead, they would look at the earnings and assets of the business to determine whether the current price was attractive or not.
So where do stop losses fit into all this?
In the eyes of many investors, stop losses are a reasonable way to control losses if a share price falls dramatically after purchase. You might set it at, say, 20% below the purchase price. You could also raise the stop loss if the share price rises, always keeping it around 20% below the current price.
Using a stop loss in the real world
It all seems so very sensible, but picture this:
You buy a house for £400,000. You buy it either to rent out or live in, it doesn’t matter which. You’re pleased with your purchase because you think the house was more fairly worth £500,000, but the seller was in a rush to move to Australia. You had the cash available and helped to close the deal quickly, which is what they wanted. They got a fast sale, and you got a cheap house.
But after you’ve bought your house, you get back in touch with the estate agent. You ask them to keep the house on the market. Okay, says the agent. Then you give the agent authority to close a deal with a buyer under one condition.
“If somebody offers you 20% less than I bought this house for, I’d like you to sell immediately on my behalf”, you say.
The agent scratches his head but agrees because all he wants is some more commission.
Does it not seem strange that you would willingly sell a house, which you thought was a bargain at £400,000, for just £320,000, just because somebody offered you that price?
Isn’t that crazy?
It only makes sense if you are a speculator. If you don’t really understand the value of the underlying asset, and instead you bought, not because you thought the house was a bargain, but because the price had been going up in recent years (and according to the greater fool theory, will continue going up until the end of time).
Because you don’t know anything about the underlying value of the asset, you have no information to go on other than what the market tells you. So when somebody offers you 20% below what you paid for it, the market is telling you that it’s not worth what you paid, which means that it is rational to sell and lock in an £80,000 loss.
But that’s only rational if you don’t understand the value of the underlying asset.
Only invest in what you understand
As an investor, it’s my job to understand, or at least have a damn good idea, what the value of the underlying asset is. That’s why I would never use a stop loss.
I sell when I think the price is significantly higher than a rational estimate of the company’s value. I certainly do not sell just because somebody offers to buy my shares for 20% less than I paid for them.