BUNK 12
STOP-LOSSES STOP LOSSES!
Stop-loss! Even the name sounds great. Who doesn’t want to stop losses? Forever! Sadly, stop-losses don’t guarantee against losses—you can lose money with them, and badly. You can also stop future gains, pay more in transaction fees, trigger taxable events, and otherwise make much less money than you would simply leaving these be. It would be more accurate to call them “stop-gains.” In the long term and on average they’re a provable money loser.

How Do They “Work”?

A stop-loss is some mechanical methodology, like an order placed with a broker, to automatically sell a stock (or bond, exchange-traded fund [ETF], mutual fund, the whole market, whatever) when it falls to a certain dollar amount. You pick any arbitrary amount you like. People usually pick round numbers like “15 percent lower than where I bought it” or 10 percent or 20 percent—no reason; people just like round numbers. They could do 13.46 percent or 17.11 percent but they don’t. When the stock hits that amount, it’s sold. No big 80 percent drops. No disasters.
Sounds great, right? Except stop-losses don’t do what people want them to do. If, on average, they were a major money-winning strategy, every professional money manager would use them. But overwhelmingly they don’t. To my knowledge, there’s no big-name, long-term, super-successful money manager who’s ever made a practice of using them—not even occasionally.
Stop-losses don’t work because stock prices aren’t serially correlated. That means price movements by themselves don’t predict future price movements. What happened yesterday doesn’t have a lick of impact on what happens today or tomorrow. People like stop-losses because they think a stock falling a certain amount (7 percent, 10 percent, 15 percent, 17.11 percent, whatever) likely keeps falling. No! Think this through: If stock price movements dictated later movements, you could just buy stocks that have gone up a bunch. But you know, instinctively, that doesn’t work. Sometimes a stock that’s up a lot keeps going up, sometimes it goes down, or sometimes it bounces along sideways. You know that. So why don’t people understand that correctly on the downside?
There’s a school of trading dedicated to momentum investing. These folks believe (contrary to a vast body of scholarly research) that price movement is predictive. They buy winners and cut losers. They look for patterns in charts. But momentum investors don’t do better on average than any other school of investors. In fact, they mostly do worse. Name five legendary ones. Or even one!

Pick a Level, Any Level

If, against my recommendation and contrary to the industry standard investing disclosure that “past performance is not indicative of future results,” you wanted to do stop-losses, then what level would you pick? And why? Suppose you picked 20 percent, just because you like the number 20. (It’s as good a reason as any other reason to pick a stop-loss level.) When a stock drops beyond that amount, it’s basically a 50-50 chance it continues dropping or reverses course. You’re trading on a coin flip. Coin flips make bad investment advisers. (see Figure 12.1.)
For example, say your stock drops 20 percent, triggering your stop-loss, so you sell. But that was because the entire market corrected that much, and this stock went along for the ride. That wasn’t the stock’s fault—there was nothing wrong with it! You sold at a relative low, paid a transaction fee, and are in cash—and markets rebound fast. You could be sitting in cash while the market and the stock you sold quickly zoom back up—without you. You bought high, sold low. Oops. That happens all the time.
Or maybe some bad news came out, triggering the drop. You sold the stock and have cash, but now what do you buy? Can you guarantee that what you buy only goes up? Maybe you buy a replacement stock with a 20 percent stop-loss. Then that one drops 20 percent. You can play this game—buying 20 percent losers—all the way to zero. The stop-loss doesn’t guarantee that future stock purchases only rise.
Figure 12.1 Stop-Losses—Trading on a Coin Flip
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Or, suppose the first stock you automatically sold then reversed course and zoomed up 80 percent over the next year. You missed that gain! You sold at a relative low, paid two transaction fees, and missed out on the good part. Maybe you tell yourself you’ll buy back once you think the trouble has passed, but I say, “Garbage.” If you sold automatically, what fundamentals are you looking at to tell you to buy back in?
Here’s another way to see this. Suppose you buy XYZ stock at $50 and it zooms to $100. Then your friend Bob buys it, and it drops to $80—down 20 percent. Should you both sell? Or just you, with your lower cost basis? Or just him?
The only certainty with stop-losses is increased transaction costs (which is, no doubt, why parts of the brokerage world have promoted them). There’s no evidence they’re better strategies. They’re just pricey security blankies for nervous investors. Except blankies don’t do any real harm, while stop-losses are pernicious little suckers. Before deploying a stop-loss strategy, lock yourself in a bunker.
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