Tales of a Technician: Why I Don’t Use Stops with Investments
May 3, 2021
I view risk management differently when investing versus trading. If you want to learn about my favorite risk rules with trading, then read The Rigors of Risk Management, my February 2021 Trading Justice Newsletter. For my perspective on investing, keep reading.
Time horizon is probably the biggest difference between a trade and an investment. When I’m putting money in an investment, I’m planning on owning it for years to decades. In case it wasn’t obvious, you can’t possibly use a stop loss without risking getting knocked out prematurely when the market is suffering a garden-variety bear market.
Do you think Warren Buffet would have built his empire as large as he did if had abandoned ship during every storm that struck over the past forty years?
Not a chance.
Weathering downturns is the price the market requires to participate in the advance. You can’t have one without the other. Anything you do to minimize the downside will, to a certain extent, limit your ability to participate in the upside. This is true of both protective puts and covered calls.
But just because I’m not using stop losses, doesn’t mean I don’t have risk protocols. In the field of long-term investments, risk mitigation comes from asset allocation and position sizing.
Asset Allocation & Position Sizing
Asset allocation refers to how much of your portfolio is invested in each asset. Most often you see this illustrated with a pie chart like so:
This particular example shows a portfolio with seven different buckets. You can control the risk of your portfolio by allocating more (or less) into safer assets such as short-term bonds. A 100% stock portfolio carries greater risk than one comprised of 70% stocks, 20% bonds, 10% real estate.
Another way you can influence the overall risk profile is by increasing your diversification. This speaks to position sizing. There’s a huge difference between someone placing 5% of their net worth into a single stock and someone placing 50% into it. I’d be willing to ride the former through any and every bear market that comes our way. But if I had half of my account in a single stock, you better believe I’d puke if up in the depths of a downturn.
Small positions in lots of stocks carries less risk than huge positions in just a few.
If you want an easy way to get diversified then you can sidestep stock-picking altogether and use broadly diversified ETFs instead (like SPY, EEM, QQQ, IWM, DIA, etc.)
Investing in low-cost, broad-based ETFs like this allows you to carry positions into corrections with greater conviction. Not all companies escape a recession or economic downturn unscathed. Some go bankrupt or suffer catastrophic losses, never to recover. But the market as a whole? It not only recovers, it eventually goes on to new heights. It simply requires time and patience.
Because of this, we could say the best risk management during times of market upheaval is simply keeping your grubby digits off the sell button.
Back to Those Stop Losses
Some rookie traders often ask why I don’t get stopped out of investments when they go down and then get back in when they start to go back up.
It’s a great, if naive, question.
The answer is because the market doesn’t allow you to do it consistently. It’s too hard to time things perfectly. Half the time, I’ll end up having to buy back at higher prices. The other half I might be able to buy back in at lower prices, but it’s not worth all the drama. I get to try to time the market to my heart’s content when active trading. If my timing is spot-on then that’s where I most benefit.
I don’t want to muddy the waters and over complicate my investments.
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