Over the past few weeks, I've read a number of headlines promoting the idea of cutting your losses as early as you can; say, after a 5%-10% stock price decline. Stop-loss orders may have their place, but not as a mainstay of most investors' repertoires. The financial press usually mentions two situations for a stop-loss: right when you buy a stock, and after it has appreciated. Both are way too short-term for my investing style, which is based on developing long-term theses for my investments. When I've got such a thesis in mind, I'm interested in bailing only if the car is indeed driving off a cliff -- not after a speed bump.
As a value guy, I'm always looking for bargains, especially after significant drops in price because of negative events -- potential overreactions, in other words. To protect my portfolio, I buy only when I have enough margin of safety, defined as the difference between the market value of the company and my own estimate. In my experience, many stocks go down farther than I expect. (Note to self: try waiting longer.) I've incurred losses of 50%-75% in the short term. But had I executed stop-loss orders, I would have missed out on some handsome rewards that Steak 'n Shake (NYSE:SNS), Nike (NYSE:NKE), and AES (NYSE:AES) provided.
None of us has any idea what will happen to short-term prices. I cannot guess with any precision the price of a stock tomorrow, in a week, or in a month. Do I think shoemaker and Motley Fool Hidden Gems newsletter pick DeckersOutdoor (NASDAQ:DECK) is undervalued today? Yes. Will the stock price be up or down in a month? I have no idea, although I believe that the company is more valuable than it's priced today. I'll have to see whether the market recognizes its value and closes the gap. If I'm not at all confident the market will close that gap at some point, I have no business investing in that stock, pure and simple.
Protecting short-term profits from loss is another popular way of using a stop-loss order. But using it to protect profits implies that you are either gambling on the market's temperament (not a good idea) or don't really have an estimate of the value of your stock. If you did, you would have an idea whether the stock was overvalued (time to sell) or still undervalued (continue to hold).
Investing like this takes knowledge and patience. You have to know what a company does and how it creates value. You have to know how to value companies and buy when your estimates exceed market prices. And you have to be willing to wait for the market to recognize the value.
People don't like losing -- especially when what they're losing is money. That's just human nature, and the urge to make back one's losses is a big reason why gambling is so addictive. In my opinion, investors shouldn't turn the stock market into a casino by falling prey to stop-loss thinking. Their portfolios will be better off for it in the long run.
Fool contributor David Meier owns shares Nike, AES, and Deckers Outdoors. He does not own shares in any of the other companies mentioned. The Motley Fool has a disclosure policy.
