Stop Loss: A Good Sign You're Lost & Should Stop

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Aug 22, 2012
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It’s not too difficult to find investment strategies that are inherently flawed; two of my personal favorites are beta as a measure of risk and stop-loss orders. I’ve written about beta in the past, so I’ll focus this article on the stop-loss order. In my mind, it doesn’t get much more idiotic than this: Someone buys a business at “X” and immediately determines that if the investment becomes more attractive (meaning they are able to buy more at a lower cost, say 99% of “X”), they will sell it immediately. I would love to see the shareholder response if a company drafted the following press release:

“ABC Corporation today announced that its Board of Directors has received and unanimously rejected an unsolicited proposal from XYZ to enter into a transaction under which XYZ would acquire ABC for $20 per share in cash. ABC’s board reviewed the offer with the assistance of its independent financial and legal advisers and concluded that the proposal is grossly inadequate; with that being said, if other market participants indicate interest in the company at a price below $20 per share, our board would be more than happy to consider this much improved offer.”

Warren Buffett wrote about a form of the stop-loss order that was partially responsible for the crash of 1987:

“We have ‘professional’ investors, those who manage many billions, to thank for most of this turmoil. Instead of focusing on what businesses will do in the years ahead, many prestigious money managers now focus on what they expect other money managers to do in the days ahead. For them, stocks are merely tokens in a game, like the thimble and flatiron in Monopoly.

An extreme example of what their attitude leads to is 'portfolio insurance,' a money-management strategy that many leading investment advisers embraced in 1986-1987. This strategy — which is simply an exotically labeled version of the small speculator's stop-loss order — dictates that ever-increasing portions of a stock portfolio, or their index-future equivalents, be sold as prices decline. The strategy says nothing else matters: A downtick of a given magnitude automatically produces a huge sell order. According to the Brady Report, $60 billion to $90 billion of equities were poised on this hair trigger in mid-October of 1987.

If you've thought that investment advisers were hired to invest, you may be bewildered by this technique. After buying a farm, would a rational owner next order his real estate agent to start selling off pieces of it whenever a neighboring property was sold at a lower price? Or would you sell your house to whatever bidder was available at 9:31 on some morning merely because at 9:30 a similar house sold for less than it would have brought on the previous day?

Moves like that, however, are what portfolio insurance tells a pension fund or university to make when it owns a portion of enterprises such as Ford or General Electric. The less these companies are being valued at, says this approach, the more vigorously they should be sold. As a 'logical' corollary, the approach commands the institutions to repurchase these companies — I'm not making this up — once their prices have rebounded significantly. Considering that huge sums are controlled by managers following such Alice-in-Wonderland practices, is it any surprise that markets sometimes behave in aberrational fashion?”

Many market participants suffer from two critical shortfalls: They don’t have the slightest clue on how to conservatively value a business, and they don’t think like owners. As a result, they cannot take advantage of opportunity (lower prices), and instead see it as a sign of defeat.

Unfortunately, volatility is a reality: Even the safest companies (and some of the best investments of the past half-century) will periodically have their face pushed in the mud. A fantastic example of this is Berkshire Hathaway (BRK.A)(BRK.B, Financial): Since 1965, book value has increased at a compounded annual rate of 19.8% (book value went from $19 to $99,860 per share), and has only declined on a per share basis twice in that entire period, both times by single digits; that is a truly astounding record on the back of persistent advances higher.

With that information, one would assume that Berkshire has been relatively stable in comparison to most publicly traded companies, and that a stop-loss of 50% (many would argue that this is adequate room for volatility and that any decline of this magnitude would signal serious problems) would likely never be triggered; would it have held up over the past 47 years? Our answer comes from an interview with Charlie Munger that took place in during October 2009:

Question: “How worried are you by the declines in the share price of Berkshire Hathaway?”

Charlie: “Zero. This is the third time that Warren and I have seen our holdings in Berkshire go down top tick to bottom tick by 50%. I think it’s in the nature of long term shareholding, of the normal vicissitudes in worldly outcomes and in markets, that the long term holder has his quoted value of the stock go down by say 50%. I think you can argue that if you’re not willing to react with equanimity to a market price decline of 50% two or three times a century, you’re not fit to be a common shareholder and you deserve the mediocre result you are going to get compared to the people who do have the temperament, who can be more philosophical about these market fluctuations.

I revert back to what I wrote above: Without the mindset of an owner and the ability to conservatively value the business in question (which means staying within your circle of competence), it will be painfully difficult to stick with companies that are experiencing periods of poor share performance. My simple test is the following: When you buy any stock, simply ask yourself, if the shares decline 25% in the next six months, am I a buyer? If you are feeling queasy as you contemplate this, that’s a good indication that you may be setting yourself up for disaster (if a company’s competitive position in an industry can materially change in 6 to 12 months, that’s a warning sign as well).

Many people don’t think about this until they are deep in the red; if you focus on the downside now rather than later (and find yourself not only prepared for it but hoping for it), you can avoid a regrettable situation that has caused many investors sleepless nights and mediocre results.

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