Why Planning For Losses Is More Important Than The Research To Buy

If your sitting in a few value traps after the recent market dip, the thought of stop losses may be circulating in your mind. I find there is more confusion surrounding stop losses than any other investment topic. The placement of a stop loss is both an art and a science and one of the most difficult concepts for value investors to grasp.

Investors have such a despise for stops because the brain weighs losses three times as much as gains. So, if you’re down 10% in one position and up 10% on another position you are break even on paper but you’re down 20% in your brain. It’s a complex situation and this is the reason so few people want to cut losses. It’s emotionally too hard. Unfortunately, it’s also the key tool if you want to be a successful value investor.

The fear of losing clouds out the insight that you can always reenter and investment after you sell it. Unfortunately, it has been ingrained into value investors that enduring large drawdowns and pain is part of the process of investing because you can’t time the market. This is a weak argument. As I have pointed out repeatedly value investing involves buying shares of a company that is experiencing trouble.

During the initial descent of a company into trouble, the share price often declines much more rapidly than the fundamentals. That’s why the stock appears to be a great bargain when looking at stats such as price to book or p/e. Eventually, the fundamentals will slowly and surely catch up to the declining share price and the bargain you originally purchased based on past stats disappears.

Being early can often cause catastrophic losses as a company’s operating leverage works against it. That stock you bought at $30 may not bottom till $5 bucks as revenue declines coupled with weaker margins massacres EBITDA margins and earnings.

During this descent, many investors continue to average down thinking the margins of the past will return. This is a strategy based on hope and not reality. By the time margins and revenue have bottomed, investors have burnt up not only their physical capital but their psychological capital. The thought of buying more shares when it appears that the fundamentals have bottomed now become impossible. At this point, you’re just praying you can get back to even.

This is why I encourage everyone to have a stop loss when they enter an investment or some sort of tripwire. You need to realize that even the best business people can sometimes never fix a company or that past margins will never return. The hardest part of investing is not buying it’s the planning and executing stop losses. You need to put as much thought into planning your exit as you put into the research to buy.

I suggest you read my blog post “stop losses and separating emotions from reason”