Some questions written in to turtletrader.com that help to understand trend following a bit more:
Q. I always buy a stock with the intention of holding it forever. That’s my default position. As Warren Buffett once said, Inactivity strikes us as intelligent behavior. For one thing, if you don’t sell, you don’t have to pay capital gains taxes.
A. Do not make market decisions based on tax consequences. Why? WorldCom is a fine example of holding on to not pay taxes to only see your share price drop to 10. But at least you don’t have to pay taxes!
Q. I never sell just because a stock has fallen in price. If you have faith in the businesses you own, then when they fall you must buy more shares — they’re on sale.
Q. I think a popular, but misguided, selling technique is putting a stop-loss under a stock. The problem with a stop-loss is that you get whipsawed. The dip was temporary, but your loss is permanent. A stop-loss makes no sense.
A. Not having a stop loss is suicide. The best traders use some form of a stop. Period. Buy and hold true believers do not use stops.
Q. When you buy a share of stock, you become a partner in a business. That was an adage of the late financial scholar Benjamin Graham, Buffett’s mentor, and it may be the most important concept in investing. Your decision to sell must be based not on what’s happening to the stock, but on what’s going on within the business.
A. When you buy a stock you are only worried about profit. That’s it. If the great accounting scandals have proven anything it’s that you can only know one true fact: the price. The price is the only number that does not lie. How can you ever truly know what’s going on in a business? You can’t. More importantly, trend following does not require such impossible to gather data.
Q. When do you sell? You sell when the business has deteriorated in a significant way. And what does that mean? Turn to Common Stocks and Uncommon Profits, the 1958 book by Philip Fisher. It offers the best single statement about selling. It is only occasionally, writes Mr. Fisher, that there is any reason for selling at all. And the main one is business deterioration. When companies deteriorate, they usually do so for one of two reasons. Either there has been a deterioration of management, or the company no longer has the prospect of increasing the markets for its product in the way it formerly did.
A. The only way to judge a business is through its price. Deterioration of management? Impossible goal. When were we to know WorldCom’s management had deteriorated? Once they take people to jail and the share price is 10? Is that when we must act? We think not. The price of WorldCom gave clues long before the stock crashed.
Q. The same with stocks: Buy stocks that you intend to love for a long time — and stick with them. But remember that a stock represents a business, and, when its management or its products fail you, sell — without delay and without sentimentality. What’s wrong with that?
A. How do you know when management fails? Doesn’t management always admit failure after the fact? Management failure can occur when a stock is at all time high too. Does anyone think they will admit something wrong then? The only thing you can judge is the stock price. Yes, we know it’s a redundant message.
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