Stop Loss (#423)
Don't let pride or loss aversion keep you from walking away from bad investments of time, effort or money.
Over the years, I have made several investments, especially in the stock market. Some of these investments have gone well; others, not so well.
In the past two years, I made some particularly bad investments that led to meaningful losses. What’s frustrating is I could have mitigated my downside through a simple tactic called a stop loss.
A stop loss is an order to sell an investment if the price falls by a certain amount. For example, imagine I bought 100 shares of Acme stock for $10 each, for a total investment of $1,000. In that scenario, a stop loss would involve putting in an order to sell those shares automatically if the price falls by a certain amount—let's say to $8.50 per share.
Many people would consider this a crazy thing to do. Why would I lock in a 15 percent loss instead of just waiting for the stock to rebound?
The funny thing about luck and momentum is that you can’t assume these powerful forces will work in your favor. In some cases, negative momentum far exceeds your expectations. This occurred with the 80 percent drop I suffered in some poorly timed solar stock purchases—a 15 percent stop loss would’ve dramatically limited the damage.
We tend to be more emotional than rational in our decision making. When we lose something, especially money, we are often willing to do anything to recover that loss. This is due to a powerful behavioral economics concept called loss aversion theory.
Developed by Daniel Kahneman and Amos Tversky in 1979, loss aversion theory says that the pain of losing is psychologically about twice as powerful as the pleasure of gaining the same amount. A person’s disappointment about losing $100 would be far greater than their happiness about earning $100, even though the dollar amounts are identical.
Because of loss aversion theory, we are bad at cutting our losses. We’ll hold investments that are rapidly losing value in hopes of a rebound, and we’ll throw good money after bad in hopes of just climbing back to even. A stop loss is a hedge against that impulse, intended to prevent even greater losses.
The philosophical concept of a stop loss can also be applied beyond the business or financial world. In the moment, when we have entered into something that isn’t going well—whether it’s a job, a relationship, a new living situation or a social commitment—it's very hard to pull the ripcord and get out. If we apply a mental stop loss by defining how much time or effort we’re willing to “lose” on something and commit to walk away if we hit that point without a positive outcome, we can really limit the damage of our bad decisions or misfortune.
Applying a stop loss strategy is not being pessimistic—instead, it’s being realistic and prepared, understanding that our emotions prevent us from seeing the full downside in the heat of the moment. A stop loss mechanism pushes us to objectively evaluate situations in advance and act logically, rather than emotionally.
For example, I remember one entrepreneur telling me he had a deal with his wife about the limit he would make in any investment, no matter how well or poorly it was going. He needed that threshold to prevent himself from doubling down on something that was not going well.
As John Maynard Keynes famously observed—and Warren Buffett often echoed—"The market can remain irrational longer than you can remain solvent." Even the smartest among us won’t make good decisions all or even most of the time. The best investors, and the best leaders, assess situations rationally, and give themselves the opportunities to limit the damage of those bad decisions and allowing the chance to course correct to a more productive direction.
The emotional disappointment of locking in a small loss is nothing compared to the crushing feeling of taking a big failure you’re not prepared to handle. Had I implemented a stop loss in these investing situations, I would have been far better off. It’s a mistake I plan to avoid in the future, and it’s a concept I am working to apply outside of the investment world as well.
Where could you benefit most from cutting your losses?
Quote of The Week
“The worst time to make a decision is when you are in it.” - Annie Duke
Have a great weekend!
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Thanks for this clear piece about how we think irrationally about loss. I was once given the advice when I started a new job to list three conditions under which I would leave that job. It may be a bit imprecise (and kind of a downer when you’re excited about a new job) but it’s a great way to keep a clear head when things get rough. People stay in jobs that are not healthy for them for a long time because of the same forces you write about here.
For a stock purchase it's a lot easier to place a stop loss than in other life's decisions, investing or otherwise, where the criteria for the stop loss may not be as easily qualifiable as a stock market investment.
Social media is full of quotes and graphics telling us not to give up, ignore naysayers, and persevere, because success is just around the corner. Lots of little clips showing people giving up when success was so close.
The million-dollar question in those situations is "How do we assess the relevant from the irrelevant, the essential from the incidental, to establish the stop loss?". The factors are going to be different for every situation and for different people in similar situations.