Rory Gillen
Registered User
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Warren Buffet once said "The first rule of investing is don't lose money". On my own website, a subscriber interpreted that to mean that he should place stop-loss orders on his portfolio of shares. He chose a 15% limit for the very scientific reason that it felt about right. But he also noticed that my own website eschews the use stop-loss orders; so he asked why that was.
It was an interesting question and I repeat my response here as it has educational as well as practical investment benefits. The use of stop-losses is for traders only, and they are part and parcel of how a trader controls risk. The uncomfortable truth, however, is that most non-professional traders lose their money, if not immediately, then in time. Trading markets is a zero-sum-game as trading does not give you the time to benefit from the natural appreciation in markets that occurs over time.
The quick answer to above posed question regarding the wisdom of using stop-loss limits is; what happens if you get a general market decline of, say, 15% (which is normal enough)? You are cleared out of all your stocks, and the danger is that the market rebounds and you are out of the market. What you have ended up doing is trying to 'time' the stock or market. That's closer to speculating than it is investing.
Buffett's words are useful only if you understand the context in which they were said. To Buffett, not losing money is to avoid the risk of a permanent loss of capital; he was not talking about price volatility. One of the hardest lessons for private investors (myself included) to get right is to be able to distinguish between a share that has fallen heavily in price (volatility) but which contains no real risk of a permanent loss and a share that carries the risk of a permanent loss.
By way of example, recall in 2008 that Abbey's share price, the Irish house builder, was just as weak as the banks. But Abbey had no debt and started cutting its costs to adjust for the likely lower level of sales given the downturn in demand for housing. Abbey's shares declined in price from over €10 in 2007 to under €3 in 2008. Today, Abbey's share price is back to €10. So, in Abbey's case, the decline (volatility) was an opportunity. Contrast that with the banks back then, which had so much debt and overvalued property as security that they were, in effect, bust!
When a company's share price declines significantly the questions one must pose are as follows;
1. Have business risks risen to the extent that they could undermine the company's long-term earnings power? I refer to this as the Business Risk
2. Has the company got an uncomfortable amount of debt, which could lead to insolvency if turnover, profits and cash flows decline significantly? I refer to this as Financial Risk.
3. Do the shares remain overvalued on the basis of earnings, assets and other measures of value. I refer to this as Valuation Risk.
If you can answer these questions for the stocks you own then you are in a position to distinguish between risk and volatility. If you can’t, and that would be normal for a non-professional investor, then funds are an easier route to investing for the long-term.
These questions are so very relevant for the gold miners these days. The Philadelphia Gold & Silver Miners Index is down a whopping 67% from the peak in mid-2011. Gold and silver miners that have strong balance sheets and a history of growing output are as hammered as the average precious metal mining stock. But they’ll be the ones doubling or trebling when the dust settles, just as Glanbia, Kerry, DCC and many other Irish stocks have not only recovered fully from the pasting in 2008 but have gone on to new all-time highs.
Rory Gillen
Founder
GillenMarkets.com
It was an interesting question and I repeat my response here as it has educational as well as practical investment benefits. The use of stop-losses is for traders only, and they are part and parcel of how a trader controls risk. The uncomfortable truth, however, is that most non-professional traders lose their money, if not immediately, then in time. Trading markets is a zero-sum-game as trading does not give you the time to benefit from the natural appreciation in markets that occurs over time.
The quick answer to above posed question regarding the wisdom of using stop-loss limits is; what happens if you get a general market decline of, say, 15% (which is normal enough)? You are cleared out of all your stocks, and the danger is that the market rebounds and you are out of the market. What you have ended up doing is trying to 'time' the stock or market. That's closer to speculating than it is investing.
Buffett's words are useful only if you understand the context in which they were said. To Buffett, not losing money is to avoid the risk of a permanent loss of capital; he was not talking about price volatility. One of the hardest lessons for private investors (myself included) to get right is to be able to distinguish between a share that has fallen heavily in price (volatility) but which contains no real risk of a permanent loss and a share that carries the risk of a permanent loss.
By way of example, recall in 2008 that Abbey's share price, the Irish house builder, was just as weak as the banks. But Abbey had no debt and started cutting its costs to adjust for the likely lower level of sales given the downturn in demand for housing. Abbey's shares declined in price from over €10 in 2007 to under €3 in 2008. Today, Abbey's share price is back to €10. So, in Abbey's case, the decline (volatility) was an opportunity. Contrast that with the banks back then, which had so much debt and overvalued property as security that they were, in effect, bust!
When a company's share price declines significantly the questions one must pose are as follows;
1. Have business risks risen to the extent that they could undermine the company's long-term earnings power? I refer to this as the Business Risk
2. Has the company got an uncomfortable amount of debt, which could lead to insolvency if turnover, profits and cash flows decline significantly? I refer to this as Financial Risk.
3. Do the shares remain overvalued on the basis of earnings, assets and other measures of value. I refer to this as Valuation Risk.
If you can answer these questions for the stocks you own then you are in a position to distinguish between risk and volatility. If you can’t, and that would be normal for a non-professional investor, then funds are an easier route to investing for the long-term.
These questions are so very relevant for the gold miners these days. The Philadelphia Gold & Silver Miners Index is down a whopping 67% from the peak in mid-2011. Gold and silver miners that have strong balance sheets and a history of growing output are as hammered as the average precious metal mining stock. But they’ll be the ones doubling or trebling when the dust settles, just as Glanbia, Kerry, DCC and many other Irish stocks have not only recovered fully from the pasting in 2008 but have gone on to new all-time highs.
Rory Gillen
Founder
GillenMarkets.com
