Post by fastwalker on Aug 26, 2004 16:11:47 GMT -5
FYI....Why Stop-Loss Orders Are a Bad Sell
The answers to Dennis' questions are none and no. A stop-loss order is an automatic sell order that is triggered when a stock price drops below a predetermined level. Such orders might be used by momentum traders who buy stocks solely because the most recent price change is up, and sell them solely because the most recent price change is down. This makes no sense to value investors like us; we want to buy cheap stocks, not sell them.
To put stop-loss orders in perspective, imagine that you and your neighbor own two-year-old cars of the same model with a Blue Book value of $10,000. Your neighbor posts a sign in his yard advertising the sale of his car, and the two of you sit on his porch drinking lemonade while awaiting prospective buyers. The first person to stop and look at the car offers $9,500, but your neighbor declines the offer. The next buyer offers only $8,500. Your neighbor declines again, but now he seems disappointed and worried by the lowball offers. The third visitor offers only $7,500. Your neighbor becomes distressed and tells you that he is going to sell for $7,500 because his car price is "crashing" and he needs to "get out" while he can.
Presented with this situation, you might: A) Rush over to the buyer and offer him your car for $7,450 so that you, too, can "get out" before the price drops below $7,000. B) Offer to buy your neighbor's car for $7,550 because you believe you can sell it soon enough for the Blue Book value of $10,000. C) Advise your neighbor to take some aspirin and lie down in a cool, dark room while he collects his senses. If you picked option "A", you chose a stop-loss order.
The scenario above is unlikely because most of us have a pretty firm grasp of the value of our vehicles. We'd rather collect the "dividends" of car ownership (driving the car) than sell for an absurdly low price. On the other hand, many stock owners seem to view that possession as nothing more than a squiggly line on a price chart. If an investor doesn't know what his holdings are worth, falling prices might seem like a reason to sell.
A stock is not just squiggly line on a chart. It is a claim on a company's earnings. That claim has a value that can be estimated, just like the value of a house, a car, a suit, or a gallon of milk. Unless an investor can estimate that value with confidence, he or she should not buy the stock, or the house, or the car. However, once the value is known, why would an investor sell for less than fair value?
Note that a fair value estimate can change with new information. If you learned that your neighbor's car had a bad transmission, then you would estimate its worth by subtracting the cost of needed repairs from the Blue Book value of the same car in good condition. If the repairs cost $1,500 and potential buyers knew of the mechanical trouble, then your neighbor should take the second offer of $8,500. Importantly, the new information about the transmission trouble would drive the decision to sell at $8,500, not the offer itself. Your neighbor should still refuse the $7,500 offer.
Likewise, new information about a company might cause you to lower your fair value estimate, but you would have no reason to sell unless the market price was still above your assessment of the company's worth. On the contrary, if the market price fell farther than your new fair value estimate, you might consider an additional purchase. In either case, your actions should be driven by your determination of value, not by capricious short-term swings in market prices.
This line of thought is straight from the value-investing playbook. But interestingly, even the legion of investors who believe the market is always efficient have no reason to use stop-loss orders. If the market price is always the "correct" price, then every stock will provide the proper risk-adjusted return at all times. There is no reason to switch to other stocks or cash unless an investor wants to change his or her risk level, but this decision is not affected by price changes, either. Remember, a stop-loss order is an action driven by price changes, which means putting the cart before the horse.
Further, stop-loss orders do not actually lower risk. If you are willing to own a stock for the long term, short-term price drops are inconsequential. It is highly likely that the stock price will match the company's fair value at some point during your holding period. Your only risk is that you overestimate the value of a company and suffer a substandard return because of your mistake. The way to control this risk is to invest within your field of competence, study each purchase thoroughly, and require a purchase price below your best estimate of the company's worth. In other words, know what you are doing, and require a margin of safety before you buy.
