Mohnish Pabrai recently did a great interview with BloombergQuint, the Indian financial news organisation. While Pabrai has said many times that he’s not a fan of stop-losses, in this interview he provides a great example of how stop-losses can seriously hurt your performance.
Here’s an excerpt from the interview:
Pabrai: So just to clarify, we’re not talking about the speculators and traders. More power to them!
But when we come to investors I actually find plenty of pundits on TV who have done fundamental analysis and they give targets and they give stop-losses. I find that really peculiar. One of the reasons why we can make a lot of money in equity markets is because their auction driven, and auction driven markets are very different from almost any other kind of market.
So to give you an illustration. Let’s say I bought a flat in Mumbai for one crore (US $155,000). I don’t know if we can get one for one crore or not but let’s play along. We got one, maybe in the periphery of Mumbai.
Okay so we paid a crore (US $155,000) for the flat and we did research and we found that it’s the right price and we bought it. Now we want to know how the price of that flat changes every day.
So I have a friend who’s a real estate broker and I tell my friend the real estate broker, listen we’re going to have chai with Pabrai every day, you and I are going to have a cup of tea. Every day just come and tell me what the market price of my flat is okay.
So you bought the flat. Next day you invite your broker friend. I ask him, what’s the price of the flat? He’d say, “listen idiot it’s still one crore (US $155,000)”.
Okay, I call him after two days, he still says one crore (US $155,000), and after maybe two months he says, “You know the little change in transactions it’s 1.005 crores (US $157,000). It’s gone up a little bit.
And if you did this every day and you just wrote down the price he was giving you. Did it for 365 days, you would at the extreme end find that it went to somewhere between 95 lakhs (US $148,000) and maybe 1.1 crores (US $172,000) or 1.15 crores (US $180,000), in that range.
Now, let’s say my flat is a listed company on the Bombay Stock Exchange. But the only asset is this flat, and every day the price is doing whatever it’s doing in the market, and we chart that daily price movement.
What we’re gonna find is in a 52 week period the range maybe something between 70 lakhs (US $108,000) and 1.3 crores (US $203,000), and the reason is that auction driven markets undershoot and overshoot, and it is the under shooting and over shooting that creates the opportunity for people like me.
So basically the idea of a stop-loss would be, I bought the flat for a crore (US $155,000) and after six months my broker tells me, “You know prices have dropped about five percent”. I say to him okay that’s my stop-loss and I’m now going to sell you my flat for ninety five lakhs (US $148,000). Please sell it. It would be the equivalent of doing that.
The reason you bought the flat for one crore (US $155,000) was because you thought that it was fairly priced. The second reason you bought it is because you wanted to hold it as a long-term asset. So the same thing with stocks.
If you bought a stock for two hundred rupees (US $3.13) or it has a market cap of 1000 crores (US $156 Million), you bought it because you thought it’s worth two thousand crores (US $312 Million). So if it goes from one thousand crores (US $156 Million) to nine hundred crores (US $141 Million) you will sell it with stop-losses. It makes no sense.
So I own a company called Rain Industries. I bought that stock about two and a half years ago. And when I was buying the stock it was at about thirty rupees (US $0.47) a share. By the time I finished buying it got up to forty five rupees (US $0.70) a share. Went up almost fifty percent because I almost bought ten percent of the business.
After I finished buying it proceeded to go down. Just like everything I buy. The stock knows that I bought it and it decides Mohnish is done now let’s go down.
If I had engaged in stop-losses, Rain went down to forty (US $0.63), even went down to thirty five (US $0.55) after I finished buying, and I did nothing. So now Rain is north off, I don’t know, three hundred and sixty rupees (US $5.64). So that whole opportunity would have been gone. It would have been no sense for me to put a stop-loss at thirty or thirty-five or forty because I thought it was worth a lot more.
I think investors ought to focus on making sure that the stock is within their circle of competence. That it’s worth a lot more than its valued at and, once you have those two things a stop-loss makes no sense.
*Special thanks to Sumanth Culli, one of our readers, who helped me with some tricky crore, lakh, and rupee conversions.
You can watch the entire interview here.
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Mohnish is correct if we can answer “yes” to each of these questions:
1 I know why the price has declined
2 My thesis is still intact
3 I have an edge (information, analytic, structural, emotional, or control-influence)
4 I have a catalyst
5 I can afford the consequences
Otherwise, we should determine before we buy a stock how much we are willing to lose, and then if our stop loss is hit, sell. This way, we minimize the risk of turning a recoverable small loss into a devastating big loss.
26,000 U.S. stocks produced $35 trillion of stock market profits during 1926-2016, according to a study by Prof. Hendrik Bessembinder of U of AZ. (This is equivalent to the market value of about 35 Apples, or the net worth of about 500 Warren Buffett’s.)
And yet, just 1,000 of these stocks made money during their lives as public companies, and the other 25,000 companies broke even or lost money.
In other words, a buy-and-hold investor of randomly selected individual stocks has just a four percent chance of making money. (Presumably, your winning percentage improves if you buy at a discount to intrinsic value and apply other filters.)
If you like the company but can’t answer “yes” to the five questions above, maybe you keep a one percent stake to remind you to follow the company.
Andrew Lo at MIT says stop losses can increase expected return and also reduce volatility:
Author, “Its’Earnings That Count” (McGraw-Hill, 2004)
So basically stop losses are used by people who don’t know what they are doing. Sounds like they are not going to do very well in either case.
I personally think that most larger funds want you (the average Joe) not to use a stop loss as it magnifies their losses when things go wrong. Its obvious the larger funds cannot sell out on a whim. They try counteract this by preaching to small investors that stop losses are somehow a bad idea.
For the small / less informed investor a stop loss is your (free to use) 1960s seatbelt. You could still get killed as a big gap down will not trigger your limit price – but for the transactional price of selling out and buying back in if the price recovers (or putting the money to use elsewhere) it is logically worth it providing that you are dealing in stocks with a low spread and high liquidity.
DYOR is not enough these days. Having a solid thesis / edge is total horse manure as a stand alone concept. When you get carried away with your own “Wolf of Wall Street” god complex – just realise that you are up against a massive! massive!! amount of competition. Could you become a top 100 tennis player without having near lifelong specialised training coupled with starting before the age of 6 or 7 these days?.
Everyone likes to think they have an edge but in reality 99% of edge is ego. Unless you have been putting 1000s of hours in like the top 100 have coupled with specialised coaching / insight such as a modern day Graham as a lecturer, tutor or even family friend + access to industry conferences, research, external industry experts etc you are not going to have much of an edge (please prove me wrong). There are a lot of people now who can do discounted cashflow, there are a lot of accountants and finance experts out there who invest their own money. What makes you better?
The alternative is to take everything the titans tell us at face value – they seem to have a surprising amount of time to do interviews, conferences, write books articles for our benefit these days. If my thesis on these kindred spirits and their special type of caring kindness is correct then the titans of investing tend to suffer from the most acute form of informational altruism which counters every logical aspect of their occupation.
Buffett certainly didnt tell people how to invest as he did, at one stage he was spooked and paranoid that his office was being tapped when it turned out the market was catching on to his special situation / value edge.
Take for example business. For anyone who had their own business regardless of how small you will know from day one instinctively that its a ruthless market out there. You will also know that every industry has its secrets, its monopolies, every successful company has to guard their relationships, their processes, their patents, their informational advantage. How is investing any different?. Steve Jobs didn’t tell people about the inner workings of apples corporate strategy, or anything that would weaken their own agenda so why would Pabrai or Buffett or most other value investors for that matter?
The reality is that investing is a ruthless market no different to business . Buffett, Munger, Pabrai, Spier, and the value brigade preach better than my local vicar. Only I know my local vicar is doing it on gods behalf.
To summarise – If the stock/macro conditions are deteriorating, if the cryptocurrency market collapses, if the next Enron / Bernie Madoff appears out of the blue. If you get caught in a heavily weighted value trap. Don’t wait around for your thesis to work out – set a stop loss!
PS: There is a simple law of averages that a lot of investors will encounter called “bad luck” when picking individual stocks. Especially in concentrated portfolios. Don’t fool yourself and leave that stuff to the speculators.
People like Pabrai would have given a proverbial arm and leg to have had a solution like a stop loss on VRX or Horsehead Holdings before they imploded.
Stop losses backtest terribly. Hence I don’t like them.
Hi Toby – what do you think of the studies that show that putting a 10-20% stop loss would have improved results (or at the very least reduced drawdowns). Noted that it doesn’t account for speads/transaction costs but in principle I haven’t seen very much to counter this research.
That’s interesting. I’ve never encountered a study that showed better performance from a stop loss. Can you share the link?
I’ve emailed you Toby.
Could you post the study here as well?