Wednesday, June 17, 2015

Why Dividend Investors should never use stop losses?

A stop loss is a price below current stock prices, at which point a sell order is automatically triggered for an investor’s position.

I believe that dividend investors should never use stop loss orders, unless they are considering swing trading or day trading. If you are a swing, day trader or momentum trader, please ignore this article – you will not learn anything new from it. If you are a dividend investor, then you should think twice before using a stop loss. You want to sell shares at your own terms, not because the moody Mr Market triggers a stop loss order, or forces a margin call on you because of a temporary fluctuation in prices.

Investing is a very competitive game. This is why hedge funds and high frequency traders are paying millions of dollars in order to locate their servers as close to exchanges as possible. This is in an effort to front-run orders by fractions of milliseconds and profit in the process. In this competitive game, by placing your stop loss order, you are essentially showing off your hand to hedge funds and high frequency traders. This makes you vulnerable to stock price fluctuations, which temporarily go down, resulting in a sale. As a long-term investor, you do not want to fall prey to the moody Mr Market and sell because of a drop in prices. You want to be able to buy and hold shares at your own terms. You want to take advantage of stock price fluctuations, which make great businesses available at low prices. You do not want to be a victim of unfavorable stock price fluctuations, that would cause you to sell at a loss, due to a stop-loss order or a margin call.

In my studies of investing, I read a few books describing trading back in the day of pit trading 40 years ago. Pit traders would push markets next to areas where stop losses would be triggered, and use information for their own gain. Typically, after all the selling from stop losses is done, prices reversed course. This is why most of the people that try to time the markets are having a hard time doing it. I find it better to focus on analyzing individual businesses that can grow intrinsic value over time, and not waste time looking at stock prices in vacuum. As Buffett says, "Price is what you pay, value is what you get".

The dangers of stop loss orders can be viewed from actual examples of real investors (source: Wall Street Journal). An investor in the Vanguard Total Stock Market Index Fund (VTI) set a stop loss order on May 5, 2010 at a price of $49.17/share, which was approximately 17% below the price at which the index was selling in the stock market. This meant that once the price of the index fund fell below $49.17/share, it would be sold immediately at the market price. On May 6, 2010 however, the flash crash caused the price to drop very quickly below $49.17/share. As a result, the shares were sold at $41.15/share. The index fund rebounded, and closed the day at $57.71/share. By using a stop loss, the investor had exposed themselves to the vagaries of Mr Market, and set themselves up to sell low.

During that famous flash crash of May 6, 2010, shares of Procter & Gamble fell from $62/share to less than $40/share in just a few minutes, before recovering. If a long-term investor had a stop loss at prices below $55/share, they would have had this order triggered, and booked a loss. They would have booked that loss when nothing materially had changed with the business of Procter of Gamble during those 10 - 15 minutes.

One reason why investors should not use stop loss orders is because with them, they are exposing themselves to the next flash crash. If someone had a stop loss against Procter & Gamble (PG) on May 6, 2010 at a price that was 15% below the closing price, they would have lost a lot of money in the craziness of the flash crash that day. The investor would have sold at a price that was 15% below the market price, and lost money in the process, since prices recovered soon after. For someone who simply held on to their shares, without having a stop loss order, they would have been fine sitting through the flash crash. The goal of the game is to be able to sit tight and undisturbed by short-term price fluctuations. This is what successful long-term investing is based on.

My game is not to buy and sell stocks actively, but to invest in a business using the stock market. If I have selected a well run business, chances are that it will earn more over time, and pay me an increasing stream of dividends over time. As a result, I would not do anything about my investment in this business, for as long as it keeps on delivering results. I would not even care if the stock market closed for ten years. This is the only way to maintain your edge and sanity in the market, especially if you are a small investor. In fact, I believe ordinary dividend investors have an edge over everyone else on Wall Street, because they can ignore short-term price fluctuations, and have the permanent capital to take a long-term approach to investing.

If I buy based on fundamentals, my exit strategy should be because of fundamentals, and not due to market fluctuations. The only reason to look at market values is for times when there is a disconnect between stock prices and fundamentals due to steep overvaluation/undervaluation. An example of deteriorating fundamentals includes a decrease in the company’s ability to pay dividends.

I believe that dividend investors have the odds in their favor, because they pick businesses to invest in based on fundamentals. By sticking to fundamentals, investors have a much longer investing horizon in place, while carefully monitoring fundamentals of course. As a result, investors are detached to the day to day market fluctuations, which makes them relatively immune to the high frequency trading going on. If the fundamentals of the business improve over time, all long term investors who held onto their stock would do well. At the end of the day, Procter & Gamble is a great business, whether the stock price closed up 1% for the day, or whether it closed down 1% for the day.

If investors do not want to hold on to a stock, they should sell it. When I observe a dividend investor placing a stop loss that is 5% – 8% under their position, they are usually doing it because they do not like the stock, but want to have maximum exposure to it in case it keeps going higher. In reality, because stock prices never go straight up or straight down but zig-zag, these investors end up selling at a price that is 5% – 8% below the price at which they made the decision to sell. This is called market timing that is solely focusing on stock price fluctuations, and does not take fundamentals into consideration. While I agree that investors should learn as much about investing as possible, they should not implement every tool available just because it is out there. I believe that time in the market is more important than timing the market.

In conclusion, I do not believe that dividend investors should be using stop loss orders. The main reason is that they expose themselves to temporary stock price fluctuations,(such as flash crashes) when they set a sell order that will be triggered at a pre-determined price below current prices. Instead, investors should sell companies only because the business itself no longer performs as expected, not because stock prices go down. Focusing exclusively on stock prices is speculation. When investors speculate, they are throwing away their edge - the ability to sit tight during stock market declines. If anything, if you like a business, it makes sense to buy those businesses when prices are 20% lower, as long as fundamentals are intact.

Full Disclosure: Long PG

Relevant Articles:

Price is what you pay, value is what you get
The Dividend Edge
Dividend Stocks For Long Term Wealth Accumulation
How to Manage Your Dividend Portfolio
Time in the market is more important than timing the market

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