Ask Colin

Would you ever consider selling everything, and not buying anything again until the chart of the market showed positive signs of recovery?

This was the end point of a long question in several parts on which I commented as I went through it:

First Preamble: My broker allows automatic stop loss points. I don't usually use them because I got sick of stocks having an intraday (probably at the open) down spike, and then rising back above. During the present situation (April/May 2005) I have only been caught twice. I didn't sell either of them because it happened so fast, but I now have automatic stops in place on them both.

I have discussed this issue before in my newsletter. Automatic stop-loss levels can be a trap, giving false security to investors. Stop-loss levels are only really effective in deep liquid markets. Thinly traded secondary stocks, like the two you quoted to me, are arguably unsuitable for automatic stop-loss orders. They are accidents waiting to happen. Stop-loss orders only work properly if there are bids available in enough volume near the last price. If there are few or no buyers, the price falls through your limit and the stop-loss order is never activated. That is bad enough, but if there are some bids inside your limit price, the stop-loss order will find them, even if they are a long way away from the last price and where subsequent trading takes place. Hence the huge slippage and the big lower shadow on the day’s candle – created by you. So, in fact you might be lucky if the spike happens so fast and goes so far that your stop-loss order is not activated. It gives you a chance to act rationally after the panic created by stop-loss orders in inappropriate stocks is finished.

I take the view that one of the things that should be thought through and written down in our investment plan is what we do if the price spikes a long way below our stop-loss level.

My own rule is that I sell at market if my sell stop is violated. It means I am wrong about the investment. In thinly traded stocks I will have to manage the order carefully. A lot of judgement is needed. It is very difficult and complicated to write down. However, in principle what I do is to accept the best bid if it is reasonably close to the last sale and there is enough volume there. If not, I place my order at the last price, if it is in the spread (which may be quite wide). If there are offers lower than the last price, I will position my order one price point below the best offer. If other offers come in lower than that in any volume, I will keep moving in front of them until my order is done. However, if there is volume bid nearby I will accept the bid. It is easy to try to save a cent and end up giving away 10c in these situations. The only time I do not hit the bid is if there is no volume there, or if it is a long, long way away from the last price. Sometimes there are no bids at all in these stocks.   

That is what I do, but it is not necessarily correct for anyone else. Each investor needs to think this through in relation to what they are trying to do. I buy uptrends. If the uptrend is violated I sell at market, because I am wrong about my investment. What I have described above is what I do when there is no liquid market. But if there is, I do not hesitate to accept the bid. There is no law that says you have to do what I do. Many very successful investors will wait for a rally and sell into that. I think that is fine, except I see stop-losses as disaster protection. Losses are inevitable in investing. They are part of the territory. What will destroy your portfolio are huge losers. Waiting for a rally that never comes may be a recipe for big losers from time to time. Whether all the money saved on the rallies is enough to offset the big losers is your judgement and should be researched.

You also mentioned that sometimes prices spike down through your stop-loss and then rebound above it. Since I buy trends and the trend is violated, I sell. This is what I call positive slippage – aka good luck. However, that is the logic of my investment plan. There are many other possible plans and rules – such as only selling if a close violates a stop. That makes no sense in the logic of my investment plan, because trends are defined by peaks and troughs, highs and lows, not closes. Many other investors use other models where the close is the relevant thing -  e.g. a closing price filter on a moving average or trend line. The key thing is not what the rule is, but that you have one that is consistent with the logic of the market model you are using and that you execute it faultlessly.

Second preamble: However I am leaking value on just about everything else I own. Nothing else has hit a stop, but because they are all falling with the rest of the market, my portfolio is losing value. And some are looking precarious with ominous chart patterns. I have very close automatic stops on them now too.

My definition of a stop-loss is where I am wrong about my investment. In my case, I am perfectly relaxed about stocks trading near my sell stop. If the stop level is violated, I sell, otherwise I hold. Since the levels I set my stops at will be just below support levels, it is very likely they will often be tested in the way you describe and hold. That is what I expect. I also expect that some will not hold at support and those I will sell without hesitation.

You wrote this preamble in early May 2005. The market had been falling for over a month. So, if the portfolio was not leaking value, it would be a miracle. Prior to that the market went up for seven months and it was still well above the starting point in August 2004. The nature of bull markets is that they do not go up forever in a straight line. There will be big corrections at times. The bull market will also end at some point and you will give some of your profit back. An investor accepts this, knowing that we cannot ever consistently get 100% of a trend. 50-75% of a trend is good.

What each investor has to think through is what stops are for and what loss they can tolerate. They then need to study decades of data in hundreds of stocks and check whether their stop-loss rule would have worked to get them out at the tolerable level. If so, it has a good chance of working going forward. If not, the investor has a basic contradiction in their investment plan that must be resolved. They are trying to follow a plan that involves greater drawdowns (paper losses) than they can tolerate. The result is predictable – they will not follow the plan.

You say you have close stops on these stocks now. You do not say if those stops are still consistent with your original investment plan. If they are higher than the logic of your investment plan suggests, then they are accidents waiting to happen.  

Question: I am concerned that in the present situation I am just hanging on for the inevitable, and when my stops are hit, I will be sold out at even lower values than now. Would you ever consider selling everything, and not buying anything again until the chart of the market showed positive signs of recovery?

You ask what I would do. But that is the wrong question. It is only relevant to your problem if you are trading an identical investment plan and have my risk tolerance embedded in your psyche. I would be unconcerned about the situation you describe. And yes, I do sometimes quit the market completely in the situation described in my investment plan – a bear market and all my holdings have hit their sell-stops.

Then again, Warren Buffett is a pretty good investor. His plan is totally different. He might sell none of his stocks, no matter how far the market falls. What he does is consistent with the logic of his investment plan – if a stock is outstanding value and an outstanding business that has not deteriorated, he will hold it forever and maybe buy more when most people are selling.

So, you need to decide what you are trying to do. Buy-and-hold outstanding stocks, or trade short term swings, or anything in between. You need to define the methods you are going to employ to find stocks, buy them, place stop-losses, how many shares to buy and in how many lots, where you take profits, where you sell and so on. I suspect from your questions that you have not read my book Building Wealth in the Stock Market (earlier version under the title The Aggressive Investor).  I wrote it, not so that others should imitate my investment plan. That generally won’t work. Rather, I wrote down what I do, and why, as a model of what should be in an investment plan. Readers can then use the model to construct their own plan.