#investing  #education  #tqc  
Issue 38
August 11, 2019
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One of the costliest and, unfortunately, consistent mistakes many investors make is to purchase a stock and employ a “stop” price, where they will sell their stock if it declines by a predetermined amount, typically 5% or 10%. Arbitrary stop prices potentially preserve some capital in the short term, but often prevent investors from making multiples of the money they saved from using the “stop” price, in the long term. In fact, utilizing a “stop loss” will almost guarantee that an investor will grossly underperform an appropriate benchmark consisting of a basket of stocks. The reason for this is simple: almost every single publicly listed stock that doubles, triples, quadruples, quintuples or even sextuples over a one, two, five etc., year time horizon declines at least 20% in between doubling, tripling, quadrupling or quintupling, etc., at least once, and often, many times.

Absent a corporate takeover, the results of a late stage clinical trial for a small biotech company, or another atypical event, stock price gains (and losses) are almost never linear. Let’s use a few real-life examples to help frame our argument:

Over the last five years, the shares of Netflix (NFLX) have gained over 500%. However, in between quintupling during half a decade, NFLX suffered a 30% drawdown in March/April of 2014, a 38% sell-off in August of 2015, and plummeted 45% in 2018. Had an investor sold NFLX during anyone of those three corrections they would have missed out on a large percentage of NFLX’s price appreciation. Over the last five years, the shares of Amazon (AMZN) have risen over 550%! However, in between almost sextupling in those five years, AMZN lost 28% in January/February of 2016, 13% in August of 2017, 16% in March of 2018 and 33% in the 4th quarter of 2018. Had an investor dumped AMZN at any point during those four acute sell-offs, they would have forfeited a substantial sum of money.

Worth noting is that this phenomenon is not just limited to technology or biotech stocks. It applies to blue chip companies as well. For example, the shares of Bank of America (BAC) have doubled since 2014. But in between generating a 100% return over a five year period, BAC corrected 17% in April/May of 2014, 17% in August of 2015, 40% in January/February of 2016, 25% in June/July of 2016 and 33% in 2018. Had an investor panicked and sold BAC on a negative headline during any one of the examples listed above, they could very well be sitting on a realized loss, despite BAC doubling over the last five years. Even stodgy, safe and steady Johnson & Johnson (JNJ), one of the lowest volatility stocks in the S&P500, has grinded out a gain of 33% over the last 5 years (investors were also treated to dividends). However, in between rising 33%, JNJ traded down 10% in September/October of 2014, 10% in January of 2016, 10% in the last 6 months of 2016, 14% in January of in 2018 and 14% in December of 2018. If an investor sold JNJ during any one of these drawdowns, their investment portfolio might very well be in need of a JNJ band-aid.

Get Me Some Pepto or Size Accordingly

How can an investor possibly stomach a paper loss of 20%, or even 30% or more, if their investment thesis has not changed? This is one of the most emotionally difficult things to do, yet the answer is relatively straight forward and simplistic: size matters. One must size their positions accordingly. For instance, if an investor decides to allocate $25,000 to ABC stock, he or she must be willing to witness 10%, 20% or potentially more of their capital evaporate on paper, while their investment thesis is being proven out. If an investor is financially unable or emotionally unwilling to do so, then they have purchased too large a position and should immediately make the investment smaller, until they are comfortable to wait for their investment to come to fruition.

A Correct Thesis & Lower Stock Price

Even if an investors' thesis is correct, the price of the underlying stock they invested in to express that thesis might very well be lower, at least in the short term. In publicly traded securities, investors often find themselves in this conundrum. Why? The three main reasons are due to a general stock market sell-off, quarterly earnings "miss" (when a company's bottom line is less than anticipated) or a flawed investment thesis.

It has been empirically proven that over 50% of a stocks’ movement has to do with the direction of the general stock market. If Mr. Market gets in a bad mood and puts stocks on sale, if our investors’ thesis remains intact and he or she is sized appropriately, they might even consider taking advantage of Mr. Market’s emotional volatility by purchasing more stock.

Traders are laser focused on quarterly earnings reports. It is debatable if this is a wise allocation of human capital. The reasons go well beyond the scope of this article but most traders, including some professionals but especially the mom and pop kind, lose money over the long term. Unfortunately, investors read too much into earnings reports as well; the majority of them underperform too. Let us be clear, it is imperative to read a company's press release and listen to the quarterly earnings call. However, it is even more important not to panic and sell, or sell because of an arbitrary stop loss price, in reaction to that earnings call. For investors, the first and most important order of business is to ascertain if the earnings miss, revenue shortfall (when a company's sales are less than anticipated), or cut to forward guidance (when a company predicts it will sell / earn less in the future than anticipated) was because of a variable that would invalidate their thesis. If the answer is yes, they should sell. If the answer is no (many times firms miss their quarterly earnings estimates yet the fundamental drivers of the company are healthy and the underpinnings of a thesis are still valid; remember, very few things are linear in the world of publicly traded stocks) it might very well present an opportunity to buy more stock at a better price.

When to Sell

If a stock has declined 10%, 20%, 30% or any percent, is it ever a good time for that investor to liquidate? Absolutely, yes. When? The answer is relatively straightforward: if the investor's thesis changes, has been proven incorrect and/or is no longer a driver for the shares to appreciate, often because of disruption (i.e. a superior product, technology, methodology, etc.). When any or all of the three happen – and they will happen multiple times to every investor – that investor should sell, no matter where the stock happens to be trading. Sometimes Mr. Market is correct and a stock reflects a flawed investment thesis via a lower stock price, sometimes not, but regardless, if a stock is higher, lower or coincidently at the same price point an investor purchased it at, if their investment thesis changes and is no longer valid, it is imperative that they sell immediately.

How Can You Be Sure?

An investor can never be 100% certain that their thesis is correct or still valid. Investing is about handicapping different probabilities, and rarely certainty, at least if insider trading rules are adhered to. But what an investor can do is work hard and study harder to give them the best edge possible. The advent of the Internet and cheap online stock trading has lured millions of traders and investors into the marketplace. The stock market, however, may be easy to participate in, but it is difficult to profit from. If a trader or investor naively thinks they can open an online account, pull up a few charts and trade away profitably, it will be a costly miscalculation. Regrettably, it happens every day. On the flip side, the same technology that has given millions of people a cheap and easy way to lose money investing, has also provided the small number of investors who are willing to put in multiple hours of due diligence, access to robust data sets that are comprehensive and free.

Most investors are simply unwilling to do the work. But if an investor is willing to allocate a material amount of their human capital to the investment process, there is a high probability that they will be able to correctly judge if their investment thesis holds up to the inevitable scrutiny that is sure to come along with it. It is imperative to understand and appreciate that laziness is one of the last things that can still be arbitraged away on Wall Street.

But Wait!

What about the instances when honoring an arbitrary stop price prevented an investor from holding a stock down 40%, or even more, or riding it to zero!? It is true that even if an investor does engage in an appropriate amount of analysis there will be instances when they are simply wrong. As we mentioned earlier, investing is about handicapping probability, not certainty. As such, this goes back to our paragraph about appropriately sizing positions. An investor should never ever invest an amount of money, in any stock (or anything), where in the event they lose it all, their life would be materially adversely affected. That said, aside from accounting fraud or other criminal behavior, it would be almost impossible that a stock would go to zero if an investor concluded from hard work that his thesis was incorrect and sold immediately thereafter. Of course, that investor would most likely have lost money, but the investment wouldn’t be a total loss.

Occasionally investors lose money because they are wrong. Usually investors lose money because they are lazy, do not do the work, and instead rely on arbitrary, pre-determined stop loss prices. However, if an investor is sized appropriately, is willing to put in the hard work - the most important ingredient to being an astute investor - then there is rarely a reason to use “stop losses.” Again, absent an atypical event, rarely do stocks double, triple or appreciate significantly more over the course of a few months or years without declining 10%, 20%, 30% or even more in-between going up exponentially. Selling a security because it drops by a predetermined amount is grossly suboptimal way to invest.