I was recently reading a wealth management blog in which the writer was arguing that wealthy individuals are able to earn superior returns by limiting their downside through the use of trailing stops that automatically sell poor performing stocks and protect wealthy by limiting the downside. I call this type of sentiment to your attention because it is precisely the type of financial advice that sounds very reasonable and even prudent on the surface, but is far more hazardous when you think through the mechanics of the strategy.
A trailing stop order is different from a stop-loss order in that the predetermined automatic price for selling your stock can perpetually shift upward along with the price of your holding.
For instance, if you buy shares of Johnson & Johnson stock at $115, a stop loss order might be set at $100 through your brokerage house. This means that if Johnson & Johnson stock crosses at or below $100 per share, your shares are automatically sold without your active intervention. The theory is that you are limiting the scope of your loss to 15%. Even if Johnson & Johnson stock climbs to $200 per share, the order does not change. At that point, Johnson & Johnson would need to fall over $100 per share for the stop loss to kick into effect.
In contrast, a trailing stop is more flexible than the traditional stop loss because it readjusts upward if the stock price in question happens to rise—in other words, the strategy is indexed to a fixed amount below the current trading price or a fixed percentage below the current trading. Sticking with the Johnson & Johnson example, a trailing stop might be set up for 15% or $15.
If the price of Johnson & Johnson plummets as soon as you make your purchase, a stop loss order is indistinguishable from a trailing stop. However, if Johnson & Johnson rises to $130, then the trailing stop modifies your automatic sell up to $110.50 if you set your automatic sale at a price of 15% below the next high or $115 if you set your sale order at $15 below the highest price that the stock reaches.
At the surface, this type of strategy sounds like a reasonable wealth protective device to use. It sounds like an attempt to follow Benjamin Graham’s advice in The Intelligent Investor
But I have two objections to this type of investment strategy—one is philosophical, and the other is logistical.
First, I think investors should recognize that liquidity is supposed to be their friend. The ability to buy and sell a business easily is supposed to be a marketability benefit of your holdings. But way too often, this intended benefit is turned into a wealth-destroying demerit because the constant repricing of an asset makes it easy for you to forget that you actually own a slice of a business and not just a squiggly little blip on an electronic screen that arbitrarily frolics in price without rhyme or reason.
Imagine if you had bought 1,000 share of Chevron (CVX) on December 12, 2014 at a price of $102 per share for a total investment of $102,000. You set a trailing stop loss of 30% because you didn’t want to lose more than that. The stock shot up to $112 in February of 2015, meaning that your shares would automatically be sold if the stock ever fell 30% below that high water mark to $78.40.
Later that year, in August 2015, that is exactly what happened—with oil trading in the $40 range per barrel, your 1,000 shares of Chevron stock would have been sold at $78.40. Aside from receipt of a few dividends, you would have seen your invested capital diminish from $102,000 to $78,400.
My philosophical objection here is that the time you might be selling your stock according to your automated instructions also correlates to the moments when stocks are cheap or undervalued. If earnings power is intact, selling during these price declines means that you are trading away your ownership position in great businesses precisely at the moment when they are offering the best prospects for high future returns.
As Warren Buffett has said, Berkshire Hathaway has fallen by at least 50% during his stewardship over the past half century while he has produced 20% annual returns. Tolerating significant volatility in your holdings is the tradeoff that must be paid in the pursuit of passively creating wealth. Well, if the best investor of a non-cyclical business included those substantial price drops, don’t you think that any stock you buy will experience similar price volatility over an extended time period? Experimenting with any kind of automatic stop loss means that you are guaranteeing that your holdings will be liquidated at the troughs in the business cycle. If you assume that every stock in existence goes through periods when it is undervalued, then any automatic sale matches you up to sell at the moment when the stock is cheap. In my view, this is an asinine way to behave.
Now, this brings me to my logistical criticism. Some investors might say: “Oh, that’s fine. I already have as much money as I need. I just participate in the markets to have my net worth keep pace with inflation or beat it a little bit. I’m willing to give up a lot of upside so that I can preserve my wealth on the downside.”
That type of mindset ignores the manner in which stocks are traded. Many people think that stocks have to trade in one cent increments. That is to say, if Bank of America were to fall from $22 to $21.95, a lot of people think that there must be intervals in which the stock trades at $21.99, $21.98, $21.97, and $21.96.
A lot of times, this intuition proves to be true. Bank of America has volume trading of 100,000,000 per day, and so, it is easy to find buyers and sellers that are only a penny or two away from the prevailing stock price. The extreme liquidity of large-cap stocks, though, can make it possible to ignore the mechanics of what actually happens when ownership positions are traded.
In the case of Bank of America, there are 10.4 billion shares outstanding. If there is a sale of 100 shares of BAC stock, or any other amount for that matter, it means that there must be a buyer and seller on each side of the transaction. And they are free to assent to a deal at any price. Even if Bank of America recently traded at $22 per share, a buyer and seller can agree to a sale at $15 per share or $30 per share.
The reason you never see that happen is because no sane seller would agree to relinquish their shares at $15 when they can just punch in a sale order online and get $22 worth of value for each share that they are relinquishing.
And no sane buyer would pay $30 from a seller they encounter when they can just go online and punch in an order to get their hands on the stock at $22 per share (private stock sale arrangements usually only occur when someone is trying to buy or sell much more of a company’s stock than is regularly sold daily through the stock exchanges).
But it is important to remember that the nature of investing is that “all the seats in the ballpark must be filled at once, and each seatholder can scalp their ticket for whatever price they want.”
These concerns may sound theoretical when dealing with highly liquid stocks, but the flash crash that occurred on May 6, 2010 proves otherwise. On that day, internalizer activity in the electronic markets meant that the price of many blue-chip stocks dramatically dropped in morning trading before recovering later in the afternoon.
General Electric fell from $17 to $15, Coca-Cola fell from $53 to under $51, Disney fell from $33 to $31, Chevron fell from $77 to $73, IBM fell from $125 to $117, Philip Morris International fell from $47 to $38, Centurylink fell from $33 to $28, and Hewlett Packard fell from $48 to $43.
If you owned Philip Morris International stock that had a trailing stop trigger at $44, there were only trades at around $40.50, $40.20, $40.10, $39.50, $39.40, $39.30, and then a cluster in the $38 range. There were limited 100 to 10,000 blocks of Philip Morris International stock at that time. When you create any type of stop order, you are sending the following command to your brokerage house: “As soon as Philip Morris International falls to a price of $44 per share, put these shares on the market and take the best price that you can get.”
Maybe that means you sold in the in cluster at $40.50, maybe that means you were part of the cluster at $39.30. Maybe you sold at the $38 mark. Who knows? When there is a thin supply of stock that is heavily volatile, you cannot know ahead of time who you will be matched with. This means that someone owning Philip Morris International stock on the morning of May 6, 2010 with a trailing stop loss order of $44 would have automatically sold at some point when stock briefly dropped to that $38-$40 range, and then would have nothing to show for it when the stock recovered to a price of $47 at the end of the day.
If there is ever a time when a stock drops quickly and becomes thinly traded, your trailing stop order creates a command that will automatically sell your shares at whatever that quickly falling lower rate may be. If an exchange experiences another flash crash or just a single day of extreme volatility in response to some global event, your stop loss order is a guarantee that you will participate in the event by selling low, and you’re not even guaranteed of the price that you will receive. Intelligently, the New York Stock Exchange and a few others have stopped receiving stop loss orders.
If you enter a trailing stop loss order to sell stock that shows you a price of $50, it does not mean that you will receive a guarantee of $50 per share for your stock. Instead, it means that once the price of your stock falls to a price of $50 or lower, the brokerage house will execute a command instruction to match up your shares with a buyer at the best price it can immediately find. In highly liquid stocks, this usually means that you get $50.
But it is no guarantee. On a day of extreme volatility, this means that you could net $49, $45, or even $40. Remember, all you need is for these highly unusual and adverse trading conditions to occur during a single moment of your holding period for the stock. Events that have an extremely low probability of happening on any given day have a much higher likelihood of occurring just once over, say, a ten-year period.
This is why I don’t like trailing stops. As a philosophical matter, I have an aversion to selling good assets when they become cheap. As a practical matter, I am turned off by the fact that stop orders only create a sell command but do not guarantee a sale price. I view these types of alleged protective sales devices as a destroyer of wealth much more than a preserver. Ask anyone who had a trailing stop in effect on May 6, 2010.