Editor's note: In today's Weekend Edition, we're taking a break from our usual fare to share an essay from our friend and colleague, Whitney Tilson. Regular readers know Whitney was pounding the table on stocks the day the market bottomed in March, saying it was the best time to buy since the financial crisis. Stocks have since enjoyed a historic rally, leaving many wondering what to do now. In this essay, Whitney discusses his controversial opinions on stop losses...
The recent volatility in the markets underscores why I think it's a mistake for investors to use stop losses (note that my thoughts here don't apply to traders or to short selling).
This idea will go against much of what you've heard from my friends at Stansberry Research. It's not a popular opinion. In some ways, it's counterintuitive.
After all, automatically selling a stock if it moves against you by a certain percent (or if you lose a certain dollar amount) can reduce risk by capping your losses and preventing you from turning a bad investment into a disastrous one.
It's so easy to get caught up in a swirl of emotions, fail to see that you've made a mistake, dig in your heels, and not exit – or worse yet, continue adding to the position and thus magnify your losses. The hedge-fund industry is littered with the carcasses of guys – and, yes, they're all men – who have made this mistake.
So I understand why some investors choose to use stop losses...
Those who don't use them need to be able to do three things: accurately assess the intrinsic value of the businesses whose stocks they own... carefully manage risk... and control their egos and emotions.
It's true that stop losses do protect you from huge losses... But they also subject you to the mercy of the markets.
It's like entering a NASCAR race with a car that can't go more than 65 miles per hour. While you're far less likely to crash, you're never going to win the race, either.
To quote Benjamin Graham – the father of value investing and Warren Buffett's mentor – it's critical that "Mr. Market is your servant, not your master." By definition, a stop loss is the opposite, forcing you to do something based on the market's actions.
Stocks can be extremely volatile – sometimes much more so than the underlying value of a business. As an investor, your challenge is to figure out when the market is making a mistake and take advantage of it. The nature of stop losses forces you to sell at what could be the precise time you should be buying more.
Sure, you'll avoid train wrecks... But you'll also miss moonshots like Netflix (NFLX). In late 2011, I started to buy shares after they fell from $43 to $11 (split-adjusted). Over the following year, the stock bounced around... finally bottoming around early October 2012 at $7.78 – down 27% from my original purchase price.
If I had used a 20% or even a 25% stop loss, I would have sold near the bottom – right before the stock went up more than 50 times in less than six years.
Think about the underlying math... No matter how wrong you are about a stock, you can't lose more than your initial investment (assuming you don't buy more on the way down)... But your upside is infinite. (The inverse is true when shorting stocks, which is why I do recommend using stop losses on short positions.)
You only need to find – and hold on to – a few of these moonshot stocks in an investment lifetime to make a fortune.
The odds that you're clever enough to buy one of these stocks right near the bottom are slim. Far more common is that you're too early, as I was years ago at my hedge fund when we bought beverage company SodaStream at $35 a share. We then watched it fall to $22, where we bought more... A painful year or so later, it bottomed around $12, where we bought even more.
But then, over the next two years, it soared to nearly $100 before PepsiCo (PEP) acquired it for $144 a share in 2018.
We knew the company well. We correctly assessed that the problems plaguing it (and crushing the stock) were fixable. And because we didn't use a stop loss, we ended up making a fortune on it.
Keep in mind that stop losses aren't the only way to manage risk. You can also use careful position-sizing. In the case of SodaStream, we never forgot that this was a small, Israel-based company with a volatile stock, so we only made it a 3% position.
And each time we bought it on the way down, we did so cautiously. The decline in the stock price had shrunk the position size to around 2%, and we only bought it back up to a 3% to 4% position.
Similarly, when the stock started to skyrocket, we regularly trimmed it to keep the position size under 5%. That way, no matter what happened, this one position wasn't going to dictate the returns of our entire portfolio.
All this is particularly important to recognize right now. As many of us have seen in the recent crash – and recovery – general market sell-offs can kick you out of a position you would normally want to hold... even though nothing is wrong with the company or its prospects.
You don't want to sell great companies indiscriminately. Yet that's exactly what can happen when you rely on stops in a volatile market.
In summary, if you're not going to use stop losses, you need to manage risk in other ways – namely by controlling your ego and emotions... analyzing companies accurately... and managing your portfolio wisely, by appropriately diversifying and using proper position sizing.
These factors separate the winners from the losers on Wall Street. They're difficult to do well, as they're all judgment calls rooted in rationality, conservatism, and good information and analysis.
If you're able to do these things, you don't need to use stop losses... and you can make Mr. Market your servant, not your master.
Editor's note: Whitney has been vocal for years about his thoughts on stop losses, refusing to use them in anything he recommends or personally trades. This controversial view helped him grow his hedge fund from $1 million to $200 million over a 20-year period. But our online event on Thursday got him excited... He was shown a radically different, eye-opening exit strategy that could make stop losses totally obsolete. "I don't believe in stops... but I do believe in this," he says. Click here to learn more.