I wrote the following as a reply to a message board question by Hewitt Heiserman. Hewitt wrote the great book, It’s Earnings That Count.

How do you react when an investment is down ten or twenty percent?

I’m guessing you’re asking whether stop losses work rather than that specific 20% drop in 45 days limit.
Fundamental investors in general argue against using stop losses. The simple argument is stop losses guarantee a loss. Those investors often prefer to double down as the margin of safety is now perceived to be even larger.

Perhaps that attitude is born out of arrogance and an inability to face losses. Arrogance makes an investor think they are right, their analysis is right and the market is wrong. While that might work for a few super investors, most of us would be better off with a tad more doubt about our analytical abilities vs the market.

If a stock is down 20% is 45 days then you’re fighting the tape. Unless there is a near term catalyst then you should at the very least double down on your analysis rather than your position.

A money management technique employed by some traders is the reverse of doubling down. This may be a good compromise for people looking at stop looses. The concept is take part in. This means if a position is going against you sell half. If it keeps going against you then sell another half. That way your largest losses will be in your smallest positions. Whereas doubling down will see your largest losses in your largest positions and that is disastrous.

Naturally some investment that are down are even better opportunities and will go on to outperform. However, just because you sold something does not exclude you from buying it again. Also, once you’ve sold something you are in control again and can more objectively analysis the company and opportunity.

Most investors also struggle to add to winning positions, but that’s another story.

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