In the distant past, I was introduced to Bill O'Neil, a well-regarded stock analyst. He was producing investment research for thousands of companies. Three decades later I am pleased to say that I still subscribe to his software.
I was so enthused that I attended a 1994 O'Neill seminar in New York. The event went well until I asked what I thought was a fundamental question. His response to my question was not what I expected and I remain puzzled.
The Background
Bill O'Neill's investment strategy is (partially) based on periodically taking profits from each of one's holdings. In addition, he had in place "Stop Loss" levels, to sell securities that have dropped in price.
Let's say you invested in XYZ at $10 per share. If it dropped to $8.00, your stop loss was to be activated and you took the 20% loss (so far so good). But, if the stock rose to $14 (from your $10 cost base) your "stop loss" exit price could be widened to a 25% drop or $10.50 per share (these are approximate examples of O'Neill's Stop Loss investment strategy).
I was confused....why would a winning or losing trade make a difference to your risk controls? In the convention hall, I raised my hand and asked the question. Bill O'Neill peered down at me and coldly answered "Because paper profits allow you to play with the house money".
” The concept comes from the world of gambling — using the money from the casino to fuel and drive future earnings. (medium.com)
Why would this possibly make any difference? The stock doesn't know what your cost base is. If the security is liquid and can be sold for cash, why make a distinction between the amount you invested and your paper profit?
I think it makes no sense whatsoever. This concept seems to apply only to gambling and stock investing. Imagine analyzing a real estate purchase in the same regard....."I paid $500,000 for this house, it is now worth $700,000 and I am not too concerned about it dropping in price by $200,000. After all, if the price reverts to my purchase price, the loss is House Money... my original capital is still intact".
Possibly the key element with this mindset is that you are competing against the "House". This is true in gambling (casino has favourable odds), but hopefully not the basis for blue chip stock investing. There is no "House" with an advantaged position; your holdings (however large) are not material to the functioning of the markets.
Investing is emotional. It is hard to make logical decisions. Studies show that investors are much more comfortable taking profits than taking losses. It's so tempting to sell the winner and hold the losing position. It can be helpful to have a pre-established sell price when a security falls in value.
But using Stop Loss rules is very difficult. There are pros and cons. Perhaps Stop Loss rules work better for a trading strategy. If you want to hold a stock for the long term, you will need to suffer the highs and lows.
regards, Tim
Tim Morton, CFA is a retired portfolio manager with 45 years of experience working with private clients. For the past two years, the editor of mortonir.com and a contributor to Barron's. My comments are not to be taken as investment recommendations. They are purely for discussion purposes. Please see your advisor for investment advice.
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