Today I’ll start by stating the obvious: One of the great problems with being an investor is that you can’t know for sure beforehand what’s a dip and a buying opportunity, and what’s the beginning of a long-term decline or a crash.
That’s what sticks in my craw about mechanical stop-loss trading, because it doesn’t make any sense if you’ve done your research, understand the prospects for the business, and are committed to the long-term value of a company or an asset and want that exposure in your portfolio… but it does make you feel good, and it does help to avoid many catastrophic investments, even as it presents you with another challenge: When or what to buy with that money? Being out of the market entirely for long periods of time, or even heavily in cash, is a huge drag on a portfolio — mostly because a huge portion of the market’s gains tend to come in very brief periods of time, and at times when investors are feeling fairly uncertain.
You’ve probably heard some of the stats on this, but one example is that a “buy and hold” investment in the market in the beginning of 1995 would have returned almost 10% a year if held until the end of 2014, 20 years. If you take out just the ten best days of market performance from those 20 years, that average annual return drops to 6.1%… and a lot of those “best days” happened pretty close to some of the worst days, sometimes as a bounce-back after a steep decline, so if you happened to sell after the market drop on a stop loss, you would likely have been too gun-shy to buy right back in to capture the possible recovery. That’s why buy and hold performs better than the average investor, because most of us have a tendency to sell low (get out of the market after a scary fall) and buy high (only get back into the market after it has recovered and it feels better).
We would all like to believe that we’re not “most people,” of course — just like most drivers consider themselves to be above average… but most of us fall prey to the same psychological bugaboos. It’s really hard to sell a stock that made you feel smart when you bought it. It’s hard to change your base ...