The Folly of "Holding For the Long Term"

By Dr. Winton Felt

Experience has taught those who are willing to learn the folly of "holding and hoping," that a declining stock may never recover.  For example, many investors held on to LA Gear when it began to decline, refusing to take a loss when doing so would have allowed them to recover most of their money. They assumed they could get all their money back when the stock recovered, if only they hung on long enough.  LA Gear’s stock eventually became worthless, and the entire amount invested simply evaporated (not just the small amount of loss that investors were hoping to regain).  Genentech fell over 77% from its high (even though TPA was supposed to generate annual sales in the billions and Genentech had the patent rights).  Yahoo dropped from $250.06 to $8.02 (over 96%).  IBM fell over 76% from its high in 1999.  CMGI sold for $163.50 before it plunged to .28.  Broadcom was $274.75 before it dropped to $9.52.  JDS Uniphase sold for $153.42 before it declined to $1.58.  Unisys sold for $48.37 in 1987 before it dropped to $1.75.  Each of these stocks had a good story.  There are many others like them.  Any stock can have a similar drop.. 

The important thing is to have a set of pre-defined sell rules that can deal with such events so that if some of your stocks do plummet, the value of your account won’t go along for the ride.  The real issue is how far to let things deteriorate before "pulling the plug" on any one position.  That’s where stop-losses come into play.  The stop-loss may or may not be your primary sell strategy.  You may have a sell strategy that will eliminate a position at or above the stop-loss price.  If investors in the stocks mentioned above had implemented a stop-loss, they could have kept almost all of their money.  On the other hand, if they convinced themselves that it was wiser to "buy and hold," they probably lost nearly everything.  Stop-losses directly impact the safety of your account by setting limits on how much you will lose if a position turns bad. 

There is absolutely no way for a person who uses stop-losses to avoid selling some stocks just before they resume an up-trend.  This could happen regardless of where the stop-loss is set.  It is a fact of the market that stocks will sometimes drop more than they are "supposed" to drop before turning. The drop before the turn is what triggers the sale, and at the time of the sale your rule for selling cannot "know" that the stock is about to move upwards again.  It can only "know" information that is available at the time of the sale.  At that moment, the stock is dropping.  What the investor can do is place the stop so that the probability of its being triggered is acceptable for the targeted holding period.

For example, if you are trying to capture the gains of most 20-day trends, then your preferred stop might be far enough away from the stock that it will be triggered no more than once in 20 days or about 5% of the time.  Of course, you could also prefer a stop that is unlikely to be triggered more than 2% of the time or once in 50 days.  However, you probably would not place the stop so far away that the odds of its being triggered are only 1 in 1000. Your holding period would not call for it and the probable loss you would incur if it were triggered would be excessive relative to your expected gain. In general, a good rule of thumb is to plan each trade so that your loss on being stopped out will total no more than about ⅓ of your expected gain. 

The best way to determine a stop loss if the chart does not reveal clear levels of support at a reasonable distance from the stock is to use volatility-based stop losses.  The author (Dr. Winton Felt) considered this to be so important that he created such a stop loss calculator for the use of our own stockdisciplines.com traders.  In a volatile market, it is a high-risk venture to hold stocks in your account without a well-defined sell rule or without using stop losses.