Plan for stock Loss

Plan for stock Loss

When You Buy A Stock, Plan on Being Wrong

By Dr. Winton Felt

People buy a stock because they believe that the stock will rise.  If asked, they may admit that it is conceivable that the stock could decline, but they view that as extremely unlikely.  Otherwise, they would not have bought it.  Such investors are prepared for the best outcome, but they are not prepared for being wrong.  It is common for people to think, “I will sell it if it doesn’t work out, but I want to give it a chance to work.”  This means that they will tolerate some short-term plunges in stock price, because they believe that, in the long run, the stock will rise.. 

This approach has the appeal of seeming to be reasonable and mature.  The problem is that it all too often ends in disaster.  One problem is that the approach is more the expression of an attitude than a strategy.  Everything is expressed in a fuzzy or ambiguous way.  For example, what does the idea “if it doesn’t work out” actually mean?  Does it mean that if the stock drops 25% it will be sold?  What if the stock drops 10%?  Where will the line be drawn?  Does it mean that if the stock simply fluctuates between plus and minus 5% for two years it will be sold?  What if it does this for one year?  Again, where will the line be drawn?

Another problem is that the emphasis is on the potential gain rather than on the potential loss.  That is natural because the buyer believes in the stock.  He also believes in his own mind and in its ability to select a stock likely to rise.  In other words, he has an ego-investment in his selection.  When there is an ego-investment in a position and that position begins to go wrong, there is a tendency for the mind to enter a state of denial.  It refuses to believe that it has made a mistake in judgement.  After thinking a buy decision through and concluding that it is a good idea, it would seem illogical to the decision-maker that the stock would decline rather than rise.  It would make no sense at all for it to do that.  

You buy the stock of a biotech company that has a clot-busting drug created through gene-splice technology.  It is projected that this drug will generate billions per year for the company.  The FDA is expected to approve the drug by the end of the month.  After you buy the stock, the FDA decides that it wants more data.  Approval of the drug is delayed.  The stock plummets and does not reach previous levels for a very long time.  This and many other scenarios like it actually happened.  A company had a product that kills the Aids virus on contact and that would be used in medical facilities around the world to sanitize surfaces.  An announcement was made and the stock dropped from $12 to less than $1.  The head of a company and creator of a new technology dies and the stock of the company loses 90% of its value.  A company introduces a great product that will be used by millions of people, so you buy the company’s stock.  Another company sues your company claiming patent infringement and your company is forced to abandon the product.  Its stock loses 90% of its value.  A startup company with a great new product has an IPO and you buy its stock.  Another company, a major powerhouse in the same field, comes out with a similar product that it can manufacture for half the cost and sets the price accordingly.  Your company goes out of business and its stock drops to zero.

One of the first things that our traders do when considering a trade is to anticipate and prepare for the worst possible outcome.  Intel’s Any Grove once said “Only the paranoid survive.”  That is also a good motto for investors in the stock market.  Always prepare for the illogical.  Invest when you think you are right but prepare for being wrong.  Never think that a stock could not do this or that.  Extreme behavior happens.  Learn to live with it and prepare for it.  If you are always prepared for the improbable, you won’t have to be punished because of your lack of preparation.  The market will occasionally assert itself in such a way that it becomes clear that it will do what it “wants” to do, even if that behavior is outside the boundaries of probability or common sense.  Always use stop losses.  Define your sell strategy.  Have clarity about these things before you buy.