In a recent Seeking Alpha article, I heaped praise on my partner in lawfulness Robert Weinstein for steering me in the right direction way back in 2010. Bob and I work well together not because we see eye-to-eye in many areas, but because we fundamentally disagree in many others. While I cannot speak for him, I venture a guess that Bob would take exception with the views I am about to express in this article. That probably puts him in the majority. But, at least hear me out.
Why I Do Not Use Stop Losses
Back in early February of 2011, I was long a stock - with hard stop losses in place - that came crashing down:
At around 1:45 pm EST today (Thursday) Apple experienced a mini-flash crash where the stock briefly went into complete free-fall before immediately recovering half of its losses. From high to low, the stock lost $10 in 20 minutes and saw big gap downs from $352.50 to $348.00 ($4.50) over a 1-2 minute period of time.
I got stopped out of a portion of my Apple (AAPL) position that day. Very annoying, considering that what I should have done was buy more, if for no other reason than the inevitable "oversold" bounce. But, come to find out, it was some sort of glitch. I did end up selling out of AAPL shortly thereafter, on my own accord, but that's because I had primarily qualitative concerns over the future. It was not because I got shook out on a dip or a glitch or in the midst of a market correction.
Fast forward to today - if I had made the correct choice last year and stayed long instead of bailing prematurely on my AAPL position, I might actually sell on today's weakness. But, it would be with a whole 'nother mindset. Here's a position that has more than doubled in value since last year. Questions and concerns about the future seem more legitimate than they did last year. A perceived change in the long-term landscape of a company dictates my decision to sell, not some ultimately irrelevant near-term event.
I wish I would have kept a more complete diary over all of these years of investing. I tend to like more certainty, something somewhat scientifically relevant in the quantitative or empirical, but I feel pretty comfortable with this: When I get stopped out or stop myself out on weakness, the stock in question ends up coming back 8, maybe 9 out of 10 times.
Consider both sides of the coin. I generally get into long-term investments because I believe in a company's trajectory, as it stands, but, more important, several years out. As such, I feel like I have a pretty good history of unloading the stocks that dive and stay down for good before they stay down for good. When I sense a sea change, I am out.
Best Buy (BBY) and Sirius XM (SIRI) provide two excellent examples. I was long SIRI throughout parts of 2010 and at times during the first half of 2011. I had small positions in BBY late last year, both in real-life and the $10,000 portfolio. I took myself out of both stocks and articulated long-term bearish cases in both instances because I did not see management, in either case, responding to the competitive landscapes in their respective industries like I thought it would when I first went long. I got out on weakness, but long before each stock cratered. And, while both have had their periods of strength, I consider both more-than-sketchy long-term investments.
When You Should Use Stop Losses
Of course, there's no one size fits all in investing. When I write Seeking Alpha articles, construct my options investing newsletter and respond to personal communication, I try to make this clear. I cannot stand it when people (analysts and such) make general and wide-ranging stock recommendations, particularly long-term ones. How in the world can a person (or analyst) make the broadbrush statement that "you" should go long this stock at this price and sell it when it gets here?
That or any other "strategy," for that matter, does not necessarily apply to each unique individual or household the same way. The recent college graduate certainly makes different considerations when selecting stocks than the retiree. The day or swing trader needs to react differently than the long-term growth and income investor.
The distinction between trader and investor comes into play with regards to stop losses. If you trade, you would be certifiably insane to run and gun without stop losses. However, as an investor, there's quite a bit more room to wiggle.
I need to be clear here. I am not advocating that long-term investors should never use stop losses. That would be wholly irresponsible. Some always should. Long-term investors should use stop losses on their short-term trades. Long-term investors who need their money in short order - for retirement, college, a down payment on a home, what have you - ought to have stop losses set on most of their investments. If you need your cash in six months or a year and AAPL crashes again, but does not recover quickly enough or forever, you have put yourself in a potentially unfortunate situation. And, there are some personalities who simply need to use stop losses for various reasons, ranging from piece of mind to the inability, often because of time and resources, to thoroughly investigate their long-term stock selections in the first place.
That said, a difference exists between a disciplined plan to ditch dogs and cut losses and getting shook out of what remains a legitimate long-term play during periods of short-term weakness.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.