Should Value Investors Use Stop Loss?
Stop Loss is strongly recommended by professionals to protect your capital. And It is absolutely a necessity in trading but does the method really work for long term value investors? For example, does Warren Buffett use a stop loss?
Peter Lynch, one of the most successful investors in the history, was against using stop losses because the stocks are very volatile in the long term and you have to stand the wild fluctuations in the market if you want to be a successful long term growth-value investor. But stop losses are to avoid the volatility not for standing against it because stop losses would “arbitrarily” close your positions with a loss. Therefore, he stated in his book “One Up On Wall Street ” that if you show him a portfolio with a 10% stop loss he can show you a portfolio with 10% loss.
Warren Buffett once said:
“You shouldn’t own common stocks if a 50% decrease in their value in a short period of time would cause you acute distress.”
“Volatility caused by money managers who speculate irrationality with huge sums will offer the true investor more chance to make intelligent investment moves. He can be hurt by such volatility only if he is forced, by either financial or psychological pressures, to sell at untoward times”
“The true investor welcomes volatility”
“This great emphasis on volatility in corporate finance we regard as nonsense”
“Volatility is not synonymous of risk but – for those who truly understand it – of wealth”
“We steer clear of the foolhardy academic definition of risk and volatility, recognizing, instead, that volatility is a welcome creator of opportunity”
“Investors should treat volatility as a friend. High volatility permits an investor to purchase stocks that are particularly depressed and to sell stocks when they are selling at particularly high prices. The greater the volatility, the greater the opportunity to purchase stocks at very low prices and then sell stocks at very high prices”
Stop loss is a protection against volatility not against risk. And for a long term value-growth investor, volatility is not only unavoidable but also a necessity to exploit the irrationality of the Mr. Market.
The traders also profit from the volatility of the market but they have to maintain certain chance/risk ratio in order to protect and grow their capital. Therefore, they need stop loss to limit their losses when the volatility moves in the adverse direction.
In value-growth investing, the protection of the capital which means limiting the losses can be achieved from a sound portfolio strategy, especially through diversification. And a long term investment requires that the portfolio stands the volatile times which are unavoidable. But the purpose of the stop loss is closing positions due to adverse volatility.
Usually, the investors don’t put a stop loss at certain price levels but they trigger it by certain negative events when they indicate deteriorating fundamentals. One can say the investors cannot react fast enough to negative events and therefore stop loss at certain price levels can protect them from further losses. This can happen in some cases but in long term, stop loss can hurt portfolio more than its protection.
The issue gets more complicated when someone tries to be long term investor and uses margin at the same time. In this case, he should protect himself from volatility and also profit from the irrationality of the volatile markets.
“Financial academics define risk as volatility. That may be fine for theory, but for those of us who live in the real world, we define risk as permanent loss of capital. The likelihood of risk using our definition is always highest at the point where the general perception of risk is lowest”
“When people do try to measure investment risk, they typically assess the historic volatility of an investment compared to that of the overall market (beta), which derives from capital asset pricing theory. We consider the concept of beta to be irrelevant, both because volatility is not the same thing as risk and because one cannot reliably project past share price patterns into the future..”
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