T.Q. writes: “I frequently read about analysts who predict imminent market corrections or even a collapse. I’m not worried even though I’m a relatively new investor because I have an investing/trading strategy. However, I would like your thoughts on my strategy. I reason that since Internet trading gives me relatively instant trading capabilities at a low cost, I can now become somewhat of a trader instead of being limited to an investor due to time and cost constraints. Here’s the plan.
“I buy shares of xyz at $50; lots of them, and probably more than I can afford to, but I know exactly what I’m doing (I hope). I put in a sell stop at $47.5 (or $46) good-til-canceled. Then I sit back and relax, with full confidence that I’ve fully limited my risk to losses of 5% if I had the stop price at $47.5, or 8% if I put stop price at $46. If there’s a market correction, collapse, or sell-off, I’m protected. In fact, I’m sort of hoping for it due to the fact that if the bottom does fall out, I can take my principal, minus the 5% loss, and buy even more shares than I had originally if the price of xyz has dropped far enough in the aftermath. That way, when the market recovers, I’ll profit that much more.
“If the price of xyz goes up after I buy at $50, I leave everything alone. I expect to stay with xyz about a year, and of course I expect the stock to increase in that time. A win-win situation, right? Where is the flaw in my logic? It seems straightforward enough that it would work, and I wonder why everyone else isn’t doing the same thing if they are worried about a market “collapse.” Please enlighten a naive, small time investor, soon to be a “big” time investor (with respect to the fact that I’ll have more money in the stock market than I can really afford).
“Note that xyz is a heavily traded stock. I figure that in a huge down-turn, I can still sell xyz at the stop price because of my small volume; what is 40, 400, or even 4000 shares compared to daily traded volume of 20-30 millions shares traded? The two factors that I think make my strategy work are that I’ve put in a good-til-canceled order so that I do not have to monitor the market on an hourly or daily basis, and that xyz is a high volume traded stock.”
A.T.: I see three flaws in this oinkment, T.Q. (an oinkment being akin to an ointment, but with a little greedy piggishness mixed in):
First, you can get whipsawed. The stock dips down to 47-1/4, you get stopped out, it goes back up … you buy it back (or buy something else) … it dips a little and you get stopped out again. In a normal market, stocks don’t just march straight up. There will be bumps and corrections. If it was a good value at 50, why sell it at 47-1/2? Each little 5% or 8% hit adds up.
And where do you buy it back? You paid 50, you’re stopped out at 47-1/2 … presumably you won’t buy it back at 47-1/4, you’ll wait til it falls to, say, 43? To 39? Where is the bottom? But what if it doesn’t fall much – it just recovers from 46 or 47 and then gradually climbs to 180, but you never jumped back on! Because where would you have? At 47-1/4? No – that’s essentially where you sold it. When it hits 50 again? Maybe. But if it oscillates in the 47-51 range for a while, you’ll sure leave a lot of whipsaw dust on the floor of the exchange. Will you buy it back at 55? No … you’ll be too annoyed you sold at 47-1/2. Indeed, you might well never jump back on. So even though this stock quadruples, you’ve lost money – and developed a certain bitterness that knots the muscles in your neck.
Second, you can get creamed. True, stop-loss orders limit your risk. But the “full confidence” you speak of is illusory. In a bad situation, you could get a lot less than the stop-loss price you specified. Say the stock closed last night at 48 and xyz released some rotten news after the close. It opens for trading at 42. You’d get 42. So now you’re talking about a 16% loss, not 5% – which wouldn’t be so terrible, except you’re telling us that you’d be doing this with more money than you could ordinarily afford. If that meant you’d bought the stock on 50% margin – you borrowed half the money – then a 16% loss is really a 32% loss of your investment. And what if the company released really bad news, and trading in it were halted for an hour and it reopened not at 42 but at 35? Or 25?!
I’m not saying your strategy can’t work or never works, but it would have worked better the last 15 years, when stocks largely just kept going up, than it might the next 15, when we might — might — get back to a more traditional market where stocks go up and down while trending up.
And there is one more flaw in what you describe: your notion of holding xyz about a year. If you do have a gain, Uncle Sam will take 28% of it after a year (20% after 18 months). Live in California or New York? Uncle Pete or Uncle George will take a little slice, too. No, the way you were doing it before – long-term investing, and with no more than you can afford – is probably the better strategy. But you’re quite right about one thing: today’s negligible cyberspace commissions at least make this a significantly less-bad strategy than it used to be when each trade cost you $60 or $150 or $300 in commissions.
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On the day of the 1983 economic summit, James A. Baker 3rd, then chief of staff, realized Mr. Reagan had not read his briefing book. When Mr. Baker asked why, Mr. Reagan responded, 'Well, Jim, The Sound of Music was on last night.'~Professor Herbert S. Parmet reviewing President Reagan: The Role of a Lifetime
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