Every now and then I’ll see another investor mention stop losses, and how they use them as part of their exit strategy. While on the face of it these automatic selling mechanisms seem to make a lot of sense, they leave a lot to be desired both philosophically and practically.
I won’t mince my words:
stop losses are for speculators, not investors
To clear up any semantic ambiguities, investors look at businesses, estimate their value, and then try to buy below that value and sell above it. Speculators look at the market, and use the market itself as the primary means of determining value.
For example, a speculator might look at a stock which has been moving up in the past few weeks and decide that the market is telling him that this is a good investment. It must be, because other people are buying and pushing the share price up.
An investor on the other hand, would pay no attention to the historic share price action. Instead they would look at the earnings and assets of the business to determine whether the current price was attractive or not.
So where do stop losses fit into all this?
In the eyes of many investors, stop losses are a reasonable way to control losses if a share price falls dramatically after purchase. You might set it at say 20% below the purchase price. You could also raise the stop loss if the share price rises, always keeping it around 20% below the current price.
Using a stop loss in the real world
It all seems so very sensible, but picture this:
You buy a house for £400,000. You but it either to rent out or live in, it doesn’t matter which. You’re pleased with your purchase because you think the house was more fairly worth £500,000, but the seller was in a rush to move to Australia. You had the cash available and helped to close the deal quickly, which is what they wanted. They got a fast sale, you got a cheap house.
But after you’ve bought your house, you get back in touch with the estate agent. You ask them to keep the house on the market. Okay, says the agent. Then you give the agent authority to close a deal with a buyer under one condition.
“If somebody offers you 20% less than I bought this…
