Since early February volatility has returned to the stock market. Many people are shocked. They shouldn’t be, because this sort of volatility is actually normal. Far more normal in fact than the steady markets we saw in 2017. This sort of volatility however reminds us of why a patient buy and hold approach is the recommended by the doyen of investing, Warren Buffett.
Let’s explore why.
Why using a stop-loss produces a poor investment strategy.
Several people have asked us why we mostly avoid using stop-loss orders. Many inexperienced investors consider stop-loss orders to a quick fix in preventing a portfolio meltdown.
In essence they are right, but stop loss orders come with a lot of costs that hurt performance in ways people don’t seem to recognize until they’ve used them in practice.
Here’s how things proceed when you use stop loss in the real world.
The big question is where do you set a stop-loss level? Do you set it at say only 3-5% below current levels or further down say 15% below current levels.
If you set it close, say 3% then there is a good chance you’ll hit that level with normal stock price variation. So what happens after you hit a stop loss? Do you wait to see if the stock starts to rise and you buy back? What happens if you choose to wait and the stock rises back to its previous level? You’ve just locked in a loss. What happens if the stop-loss sells your shares and the price bounces back, in the SAME trading day so you don’t have a chance to buy back in. That sort of price movement happens a lot. In some stocks, it happens every day.
If you set it further away, say 10-15%. You haven’t really protected your portfolio and you are selling low. Selling at a time when you probably should be considering to buy, rather than sell. Remember the goal is to buy low, sell high. Not the other way around.
Let’s say you buy back after the stop-loss order hits, thinking it’s normal volatility. But then the stock decides to fall again. Do you set yet another stop-loss, and where do you set it? Take another 5% loss? And so on.
You can see how some investors end up falling into the never ending conversation about trading strategy and forget the biggest challenge is picking the right company stock.
A great stock that will grow for the future.
Pick something great, and then just hold.
Warren Buffett and his mentor Benjamin Graham were fond of using the metaphor that the market as a bi-polar person. Sometimes manic and over-excited and happy to pay big money for shares not worth that much. And then sometimes depressed, willing to sell shares for far less than they are worth.
This metaphor is a pretty apt description for a lot of the silly headlines you’ll see at extreme times. The dot-com boom and financial crisis were examples of each end of the spectrum. Be greedy when others are fearful in other words. This week we saw a lot of fear, so what does that tell you?
Waiting is the hardest thing.
So rather than worrying about your trading tactics, it’s better to go back to basics about your investment strategy. The better strategy is to buy something wonderful, a company with a great big competitive advantage that is growing, well run and profitable at a good price. Then simply just hold and forget about the headlines. Warren Buffett’s preferred hold time is “forever”.
Even better, is buying a widely diversified low cost ETF that follows the whole S&P 500 or Nasdaq or other country-wide index. The chance of a big haircut (aka more than 50%) in with a widely diversified index fund is a number that is almost zero. Yes, it did happen in 2008. But guess what? The following two years investors recouped most of those losses.
Never forget that cheaper stocks are a better buy.
There were some good prices going for some great companies this week and worth buying. But only those who ignore the temporary screaming headlines could do this.
But for those with existing holdings, sometimes doing nothing is the hardest thing of all.
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