Friday, September 3, 2010

Value Investors: Stopping The Losses

Stop-loss orders are often recommended to investors of all types, especially those who aren't always watching the market. For value investors, however, the benefits of stop-loss orders are not as high as they are for other market players, yet value investors still fully suffer from the drawbacks of stop-loss orders. The question therefore becomes: should value investors use stop-loss orders?

On the one hand, stop-loss orders can still serve a purpose. For example, if bad news for a company gets released during market hours and the stock goes into free-fall, a stop-loss could get an investor, still unaware of the news, out of the stock just minutes later.

On the other hand, value investors tend to understand what they are buying (lowering the risk of an unexpected impairment), prefer companies with low debt to capital levels (lowering the risk that a company will have some sort of negative credit event), and prefer to take advantage of volatility (rather than fall victim to momentum trading). As such, they are less likely to benefit from the protections offered by a stop-loss.

So while the benefits to stop-loss orders may not be as large for value investors, they still suffer from the negative effects of stop losses: when the market panics unjustifiably, stop loss orders kick in and investors are exited from their positions at prices far inferior to what they may have been willing to sell for!

Consider what happened just a couple of years ago to the parent company of United Airlines (NASDAQ: UAUA). Panic swept the market after a false rumour of bankruptcy spread throughout, causing the stock to drop 99.92% (from $12 to one penny!). Following news that the rumour was false, the stock returned near its original level. Those with stop-losses got exited at terrible prices, as the stock dropped like a rock. Even if an investor had a stop loss at $10, it would have been filled at a much lower price, since there were no buyers at $10 during this panic.

While we've previously discussed the idea that airlines do not make for very good value investments, the example depicted above can happen to any company when a market panic occurs, even if there has been no change in a company's fundamentals.

Before deciding whether or not to use stop-losses, value investors should ensure they understand both the (possibly reduced) benefits as well as the drawbacks.

1 comment:

Ankit Gupta said...

There are some very real risks where you might be on vacation and something catastrophic happens, and without stop loss orders, you could get in a lot of trouble. In reality though, I'm willing to bet it's not a major problem that warrants stop-loss orders.

1) Most of the year, you're probably available during market hours if you're an investor. Keep some email alerts going and you should be fine. Let's be safe and say this covers 85% of the market's hours.

2) The odds of something catastrophic happening are very slim, so 99% of the time you should be fine

3) If the position is limited to a portion of your portfolio, again, you'll be fine.

If you understand all of your risks with an investment, even the catastrophic events should be something you're aware of. I'm not too surprised when Ben Graham talks about the risk of nuclear war - he's clearly thought through it. I think it's Charlie Munger that says something like, "Show me where I'll die so I never go there." These investors really study where the mistakes could be made so they can avoid them - if we know there is some kind of likely catastrophic event, it should really be taken into consideration.

I'd say that by the time you really study a business, you're well aware of the risks that they face and so you naturally limit your position because you understand the risks. At least for me, it's easier for me to make a large bet when I don't know enough about a company simply because I don't know all the risks. Only one of those has proven to work though.