Reader Question: Do I use stop losses in trading?

A reader recently wrote in asking whether I use stop losses during trading. For those readers that aren’t aware of what a stop loss is, it essentially consists of an order to your broker to sell a listed share if it reaches a certain price (usually only in the event of a fall in price to minimise potential losses).

The quick answer is that, no, I do not, and never have used stop losses. The reason being that it takes decision-making authority away from me, as the investor, and gives outsources it to the market, which I neither consider to be rational, nor more informed than myself.

If I’ve invested in a company, let’s say a bank – I’ve reviewed its financials, market position, competitors, general operating environment and trading history, and come to the conclusion that it’s a good investment at the price quoted by the market that day. If the next day, the price falls 20%, that doesn’t necessarily tell me anything other than the fact that more people are now selling shares in the company than buying it and that the price has fallen.

If I was operating a stop loss at a 20% discount, this would automatically engage and sell my shares, regardless of any analysis or consideration of mitigating factors. Instead, it simply states that the price has fallen and the shares are to be sold. As a long-term investor, my strategy relies on the analysis and valuation of companies based on their tangible fundamentals – how much cash they generate, how well diversified their clients are, their trading strategy and history, debt levels etc.

By contrast, the market is comprised of hundreds of thousands of individual opinions – some are well informed, some are speculative, some are automatic robotic minds trading on signals, but as a whole, I do not believe they are automatically correct in their evaluation of a company’s approximate value.

To me, the market is essentially a tool for providing liquidity (the ability to buy and sell shares), rather than advice on any given company’s financial health and value. It is neither efficient nor intelligent – it is simply a mixing pot of a thousand conflicting opinions, held by people I’ve never met who want to do things for reasons I do not know.

When a companies share price changes, it tells me absolutely nothing about the actual company itself. It could be an indication of the market responding to the news, but equally, it might not be. For that reason, operating a stop loss is a bit like playing Russian roulette – sometimes you’ll get it right, other times…kablammo!

As an investor, the only thing I consider when buying, holding or selling shares is the long-term fundamentals of the underlying companies those shares represent. I look to hold a diverse range of companies trading at attractive valuations, that operate in a range of sectors and countries, that have low debts and high profitability and have the potential to pay a healthy and growing stream of dividends over time.

Once I’ve made an investment, I’ll hang onto it for as long as these factors continue to be true, and as a result, make only a handful of sales in a year.