Many investors, both institutional and individual, take too much risk. Taking too much risk can take a number of forms:
- Buying companies with weak balance sheets.
- Buying companies with high valuations.
- Inadequate diversification, whether by number of companies, number of industries, or some risk factor like buying only high-yielding stocks.
- And more…
There are three ways that problems can manifest themselves. The first way is ruin. An investor is so certain of himself that he uses a large amount of leverage to express his position. When the bet goes wrong, he loses it all; he is ruined. The second manifestation is near-ruin. As ruin is threatening, the investor sells everything to preserve some of his assets, often near the local bottom for that set of assets.
The third manifestation is decay. In this case the investor says, I will never take losses greater than x% of my position. Nice intention, but it raises the spectre of the death by a thousand cuts. Many assets fall before a significant rise; why get stopped out? Instead, use falls in price to re-evaluate positions, and consider adding if the original thesis is still valid.
To be a little more controversial here, I don’t trust the bold claims of most technicians who place stops on their positions, and claim to have good performance. Once one places stop orders, the probability rises for multiple small losses that exceed the few larger gains in the portfolio. Call me a skeptic, but I would rather re-evaluate my positions than automatically sell, which seems to me to be a recipe for decay.