The defense or stop-loss method of Warren Buffett's investment system, broadly speaking, is based on investing in companies with a large margin of safety.
Investing with a large margin gives you the advantage of entering a company at a point where its quote cannot drop any further or if it does, it won’t be by much.
Then, it’s just about sitting and waiting.
Of course, the difficulty comes from choosing those companies with a margin of safety in addition to the right moment to enter them.
But the reality is that when you start in ‘this’ trading, you avoid stop-losses. 'If you wait for the right time, the quote always recovers.' This is what is always rumored in the market. But just reading the comments is enough to see the number of people who are trapped and waiting for the quote to recover after years, just for not using a margin of safety in their investments.
It’s what happens when you follow someone else’s advice without confirming that the saying: 'You never lose in the long run' doesn’t always work.
With this mindset, thousands of traders switch to the world of forex, commodities, cryptocurrencies..., through futures, CFDs... with the idea of intraday trading and living off the profession.
But, what usually happens? They enter the market even with high leverage, and the account 'flies' in minutes.
Money management: NONE.
It continues to operate without stop-loss due to that old belief mentioned earlier that in the long run, you never lose. But there are a multitude of intraday traders who become long-term investors just for not taking their losses.
If you don’t use a stop, psychological factors won’t let you close a losing operation. The EGO doesn’t like to lose. It’s true; anyone can experience it when trading.
You always let the losses run in the hope of recovering them. And the case is that this happens many times, which reinforces the idea of not using the stop-loss, but with just one operation where the quote doesn’t recover, you can say goodbye to all the money in your account.
Why? Because on top of letting the losses run, you add more positions since you believe it has already dropped enough and can’t drop anymore. This way, if it rises, you will recover the money sooner. But the case is that it continues to drop and the losses multiply until you reach the Margin Call.
As I say, it’s a shame, because we would avoid most losses and always come out victorious if it weren’t for that one operation that ruins the entire strategy.
Therefore, it is essential to set a stop, yes or yes. One to calm our psychological fears and another to not squander all our money.
Not placing a stop in each and every one of our operations has the following SIDE EFFECTS:
- Total account bankruptcy: Margin Call.
- Not being able to trade anymore because we have run out of money.
- Much more time than we wish without being able to make operations in the market because we are waiting for the losses to recover. We have no liquidity.
- If we don’t close the losses, we won’t be able to open an operation in a more advantageous position, recover those small initial losses, and come out with profits.
On the other hand, PSYCHOLOGICALLY, the effect can be regrettable:
- Nervousness - What do I do now if I don’t recover the lost money?
- Low self-esteem - I'm not cut out for this, I'm a failure...
- Bad mood - The urge to hit everything around you, bad answers to family.
- Feeling of helplessness - There’s no way to fix this unless the losses are recovered again.
- Physical pain - Headaches, stomach aches, nausea, sweating, lack of concentration...
- Desperation/fear - How to get more money to average the position or recover what I am losing.
- Isolation - Stuck to the screen, ignoring everyone, monitoring the position every moment in the hope that it recovers.
- Insomnia - Checking the quote at dawn through the mobile. State of wakefulness thinking about what we are losing.
- Regret - 'If the quote returns to where I opened the operation, I promise to never trade without a stop again.'
All of the above skyrockets to incredible limits in proportion to the amount of money 'at stake'. So, is it worth putting a stop-loss in each and every one of our operations?