“Using a stop loss is like buying a house for $1 million and telling your broker to sell when he/she gets a bid for $800,000.”

— Warren Buffett

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In my book Excess Returns: A Comparative Study of the Methods of the World’s Greatest Investors, I describe in detail how dozens of very successful investors managed to beat the market by impressive margins over the past decades. The book explains the surprising similarities in the approach of these top stock pickers in all the steps of the investment process. In this and a second article, I briefly describe two common process mistakes from my book that top investors unanimously blame for why so many investors fail to beat the market.

Too many people invest in the stock market without a clearly articulated investment approach. They don’t know what they are looking for. Their buying and selling approach is erratic and inconsistent. And they take their cues from gut feeling, rumors, and the latest headline in the financial media rather than from rational considerations. Another major problem is that numerous people who fancy themselves investors incorporate elements of trading in their investment approach. One moment they are looking for bargain-priced stocks with strong competitive moats. And at another moment, they buy and sell based on price action or technical patterns.

[drizzle]First of all, let there be no misunderstanding. Momentum trading based on technical patterns can be extremely profitable. After all, the legendary trader Richard Dennis managed to turn about $400 in $200 million over the course of 15 years purely by trading on price patterns. Notwithstanding, one has to realize that trading is fundamentally different from investing. As illustrated on the following figure, true investors purchase and sell when a stock deviates from its intrinsic value. Traders, on the other hand, don’t care about a stock’s intrinsic value, because they use price action as a criterion to buy and sell.

Excess Returns

Figure: the basic philosophy of investing.
It might be tempting to believe that combining the best of investing and trading can lead to a winning strategy. And there are indeed a host of successful “fundamentals-based traders” (e.g., William O’Neil) who combine the analysis of business fundamentals with trading. But these traders use fundamentals only to identify strong stocks. Their buying and selling are still determined entirely by price action. In fact, in the hundreds of books, articles and interviews that I’ve read on investing and trading I haven’t come across a single successful method that combines trading with value investing. The reason is simple: it makes no sense to incorporate elements of momentum trading in value investing once you acknowledge that the basic philosophy of investing is incompatible with trading.

Let’s briefly look into two effective trading tools that, in the opinion of top investors, should be avoided by value investors:

  • The use of stop-loss orders for long positions: stop-loss orders are automatic sell orders that are triggered when a stock falls below a predefined price target. Stop-losses make perfect sense for traders because they want to get out of positions if the price action disconfirms their trading thesis. For investors, however, stop loss orders conflict with the basic investment philosophy. Indeed, according to that philosophy price declines make a stock more (not less) attractive – provided that the intrinsic value stands firm. Hence, true investors see price declines as potential purchase opportunities rather than reasons for a sale.
  • Pyramiding up: traders often buy more of a stock (i.e., they pyramid their position) when it goes up. This is consistent with the momentum trading philosophy, which states that strong price action is likely to continue. For investors, pyramiding makes little sense. Because investors analyze businesses fundamentally, they buy more of a rising stock only if the stock remains sufficiently undervalued at the higher price.

In the next article we look into a second process mistake: speculation versus investing. In the meantime, interested readers can always check out my book presentation. In addition, to purchase this book with a special 20% discount for ValueWalk readers use the following promotional code when checking out at the Harriman House online bookshop: EXCESS20 (available in Hardback, Paperback and as an eBook).

Excess returns The Efficient Market Hypothesis – Excess returns
Excess returns

Excess Returns

Excess Returns: A comparative study of the methods of the world's greatest investors by Frederik Vanhaverbeke [/drizzle]