Last week in my Strategy Lab column, I talked about how I've had to become very comfortable with others thinking I'm either irrational or even nuts when it comes to some of my long-term investments. I pay attention to well-discussed bear arguments when I'm on the bull side of the bet, but I now see disagreement by large numbers of investors or industry observers as essential in allowing for long-term upside.
But there's another so-called "problem" with the kind of long-term growth investing I do. When a company is charting new waters and disrupting an industry, the sentiment around the stock can ebb and flow in different directions at any time. This results in a lot of volatility. Companies like Netflix and Amazon are probably the best examples of this in my model growth portfolio. Apple and Google are better examples of my personal longer-term holdings. (I personally own all four stocks.)
I've developed a simple attitude about volatility that has always helped me sleep at night. I understand that at some point in time some of my most interesting growth investments will probably decline 50 per cent or more in value. I could have picked any number, but the important thing to keep in mind is that all great stocks will experience great drops. Learn to live through it.
Some readers may think that's easy for me to say because my model portfolio is up about 160 per cent since since inception in September 2012. But my return is irrelevant. There have been times when I've bought stocks only to watch them embark on a swift, sharp and painful drop. If this happened to you, and you allowed your emotions to get involved, it would be easy to feel as if the whole market was colluding against you. But if you leave emotions out of it and follow your beliefs about an industry or company, you can safely ignore the volatility while others run scared.
Quantitatively, I challenge readers to find me a stock with index-smashing performance over many years that hasn't experienced a huge drop at some point, if not at multiple points in time. In 2011, Netflix crashed from $300 to under $70 and only a year later it crashed from over $120 to almost $50. It now trades closer to $400. In late 2012 Apple crashed from $700 to a bottom of about $400 by early 2013. It's already recaptured about half of that move and I'm patient in my expectation for new highs. In late 2008 Amazon dropped from about $80 to $35. The stock trades above $350 today.
I got an email from a reader last week who wanted to know if I use stop-loss orders in my account. A stop-loss is a standing order to sell a stock once it drops below a certain price. People sometimes use these types of orders to limit their loss on an initial investment, or they may constantly adjust stop-loss price limits to try to sell near a peak price.
I can understand why traders, who are looking to outsmart the market in the short term, would use a stop-loss to limit their pain on any trade. It's consistent with their belief that they can time the market.
But consider the question from the angle of a long-term investor who understands that all great stocks experience great drops. Why would you implement a stop loss which effectively guarantees you'll sell too early in an epic rise? I can't predict when the big drops will happen any better than I can predict when I'm going to be run down with a common cold. Neither can I predict the per cent decline that will happen before a great stock starts rising again.
Stop loss orders are not for me, and I don't think they should be used by most long-term investors. If you are a long-term investor and you believe you can't time the market, then a stop-loss is a tool to force you to sell when Wall Street is depressed rather than when it actually makes sense.
I admit, there might be a case to occasionally use a stop-loss order when you've determined you want to sell a stock fairly soon and would like to protect yourself against large drops. But I personally never use stop-loss orders.
As a long-term investor in great companies, I think you are best served with a buy-and-hold approach. Accept that stocks, at times, drop a lot. The great ones recover and keep growing.