Updated: Jul 10, 2021
The stock you bought just got hit with a very negative new! Thank God I have set a stop-loss to it. Otherwise, I would have loss more money!
It is so common nowadays to see people tell you to put a stop-loss to a stock position.
It would prevent you from losing your entire investment when you made the wrong bet.
Well, I have only one thing to tell these peoples...
"Put a stop-loss to your trades, and you'll never be rich, ever."
The Essence of having a stop-loss is to prevent further loss when a trade goes south...
While it makes perfect sense when you hear it at first, but it is the stupidest thing ever invented since the solar powered flashlight...
but let me ask you this question: "How do you know it is going to keep going south?"
How do you know what is the proper amount for you to put a stop-loss?
15% sounds fair, or how about 20 or 30%?
How do you know?
You are essentially betting that stock dropped by 15, 20, or 30%, and it'll continue to go down...
You "Don't" know that. And if you are betting on something you don't know, and probably cannot predict, it is only fair that you get terrible results.
While I can admit I was one of them, I have used SL(stop-loss) and TP(take-profit) orders in my early years as a trader; I now despise it, and regret ever used them...
As I have mentioned, SL makes sense to beginners.
It sounds perfectly fair to prevent further loss. However, you are missing the most important things here...
"Each Stop-Loss triggered, you locked-in a loss."
Your principle is now 15%, 20%, or 30%, less...
and Congratulations, you turned Wall street into a casino!
When you begin to trade with SL, basically you are betting 15-30% of your principle on an equity price that will go up within the range of that price swing.
Now, answer my question... HOW, do you know that 30% is enough?
If your answer is you don't know, and why do you still fucking do it?
I think this is fear at work.
You want to feel that your entire principle is protected, only 30% of the money is at risk.
Ok, sure I can agree to that.
How many times can you suffer a 30% loss to your entire portfolio?
Probably not too many times...
Now, the big question is... How often are you accurate with each bets?
If your answer is anything less than 51%, you'll soon lose all your money.
At this point, probably many of you would be asking: Well then, are you suggesting we don't protect our capital at all? Since you said SL is bad, what can we do to protect our capital?
If you are expecting an AD will pop out and an insurance company will ask you to sign up... you would be disappointed...(I didn't receive the AD yet)
Before I tell you what you should do, let me dissect the situation for you.
Stop-Loss is not good, because of human nature.
You cannot predict the psychology of the human mind.
When a stock is decreasing in price, usually because investors such as you or me decided the stock is no longer worth keeping for whatever reason, and decided to sell it to others at that price.
The more people feel that way about that stock, and the price will decrease further.
Let's change the situation a little bit, and see it from a different angle.
Let's say, we're not trading stocks now, we're trading real estate.
A House in a good neighborhood is decreasing in price because more people are selling their house in the neighborhood.
The house was at $25 per square foot, but it is now at $20 per sqft. Would you put a stop-loss at $15, and ask your broker to sell your house at that price to protect your investment?
You'll lose around $200,000 at $15 per sqft, but you have protected the rest of your investment!
Most of you would probably keep the house until the price goes up again...and that's a smart move.
The question now is: "Why are you so stupid to set a stop-loss to your stocks when you don't do that to your house?"
You probably would say... "Well, a house is different from a stock."
Well, I beg to differ...
A house is a very stable asset...
1000 shares invested in S&P500, compared to the house, which one is more stable?
I think the S&P might win... because your house can be destroyed by natural disasters...
Anyway, My point is almost equally safe...
So, are you telling me to put all my assets into 1 stock and hold it forever?
No, obviously not.
Putting all your assets into 1 stock would be the same as putting all your eggs into 1 basket, and hope nothing would happen to it.
I'm advertising the diversification strategy.
Invest in multiple stocks and only invest in the top companies of their industries, and multiple industries.
If I invest in too many stocks, would that reduce my profit?
The short answer is: Yes, it would. However, it is not as bad as you think.
Diversifying your portfolio have the benefit of diversifying your gains as well.
Most importantly, it protects you from black swans, or simply put, the "unknown unpredictability."
Something that you don't know that you don't know and will bite your head off... to put it in plain American English...
Yes, I can give an example.
A black swan can be something like a comet that fell into an iphone factory that destroyed all of Apple's inventory of Iphone 20s, and killed it's CEO. At the same time, Apple inc's forgery of financial statement was discovered by a reporter.
The next day, Apple's stock fell from $125 a share to like $5 a share.
If you are one of the lucky buyer of Apple stocks, your $1 Million dollar is now worth $40k dollars...
It is extremely unlikely to happen, and probably no one would have thought it would happen, but when it does, it is destructive.
No matter how unlikely it is, it has a probability of happening.
Diversification will save you from this. Because you only put 25% of your assets into Apple, you still have 75% of other stocks that survived this event.
So, don't burn your money with SL. Protect it with Diversification instead!