How do you protect yourself from inopportune timing when buying stocks? This question is the crux of our contrarian stance on the use of stop losses. A stop loss order is a directive to sell a stock that you own if it falls to a specified price.
Proponents of stop losses typically recommend that the limit price be set between 7 and 10 percent below your purchase price. That way, so the theory goes, a small mistake does not become a big one, and with the bulk of your capital intact, you can play again.
In the management of the Contra portfolio, we never employ this strategy and there are several reasons for that. First, it’s important to understand that a stop loss order is never a guarantee that your exit from a stock will be limited to the damage expected. Your shares will get sold all right, but at what price? In an orderly, liquid market this should be at or just a little below your target, but this old bull market has a nasty habit of goring unwary investors.
Suppose you had been following the meteoric comeback of feisty Corel. On the Nasdaq the stock zoomed to a high of $44.50 on December 9, but then quickly slid back to the mid-$20s. Say you bought at $19 on December 21 and chose a stop of 7 percent, figuring to automatically get out at $17.67 in case it kept falling. But the next day, the stock opened at $13.
This would have immediately triggered your sale, say at about $12.75. Oops. That 7 percent safety net just developed a 33 percent hole overnight! What might have appeared to be an ideal situation to pick up some shares and whip out a trusty stop loss, proved to be deceiving. To add insult to injury, Corel was back to more than $20 for most of January.
These situations are not limited to volatile fliers like Corel. Just a few weeks ago, the blue-chip tech stock Lucent, which is the most widely held common stock in North America, chilled shareholders with a wild dive. The company issued a profit warning after trading closed at $69 on January 6. The next morning, it opened on the NYSE at $51.75, a drop of 25 per cent.
In fact, many of the most successful stocks, including stalwarts like IBM and Nortel, have had similar one-day jolts over the past couple of years, but have quickly recovered and moved much higher. Investors using stops not only could have been handed much larger losses than expected, but also would have been left in the ditch as these companies raced ahead.
Stop losses are like putting your car on cruise control under challenging driving conditions on the expressway. The argument for an automatic order is that it will ensure your decision-making process is not tainted by “emotion.” We would respond that in these sticky circumstances, particularly, you need full control of the vehicle.
Even in the less dramatic scenario where a stock drifts slowly downward after a purchase, why wouldn’t the company be a more compelling buy at a better price? Don’t let a temporary slump talk you out of a good stock.
This is not to say that averaging down is always a good idea — it frequently isn’t. Perhaps there is a piece of news that changes the fundamentals on which the original purchase decision was based. Perhaps buying more would unduly raise the risk on the portfolio because of overweighting.
The point is these are things an investor can think about, but only if a computer hasn’t already turned a potential loss into a real one.
The best way to avoid a wipeout is with a diversified portfolio. If no single holding is greater than 10 percent of the total, it is a lot harder to get into deep trouble.
And by all means, it’s a great idea to set a “mental” stop. After a decline of 15 to 20 percent, review your reasons for buying in the first place. Then decide whether an ejection of the stock is in order or you should hang in.
By the way, for those who do not have a lot of time to babysit their portfolios, many software programs can be configured to generate an alert when a stock hits a certain level.