Warren Buffet's investment system relies on a broad defense strategy or stop-loss mechanism, primarily focused on investing in companies with a significant margin of safety. Investing with a large margin gives you the advantage of entering a company at a point where its stock price can’t drop much further, or if it does, it won't be by much.
Then, it’s just a matter of sitting back and waiting.
Of course, the difficulty lies in selecting those companies with a margin of safety and the right timing to invest in them.
The reality is that when you start in "this" trading business, you tend to avoid stop-losses.
_“If you wait long enough, the stock price always recovers.” This is the market rumor. But a quick look at the comments reveals many people trapped and waiting for the stock price to recover for years, precisely because they didn't use a margin of safety in their investments.
Following others' advice without verifying the saying, "You never lose in the long run," doesn't always work.
With this mindset, thousands of traders shift to forex, commodities, cryptocurrencies... through futures, CFDs... aiming to day trade and make a living.
But what usually happens? They enter the market, often with high leverage, and their account “flies” away in minutes.
Money management: NONE.
They continue trading without stop-losses due to that old belief that you never lose in the long run. But many day traders turn into long-term investors just because they don’t want to accept their losses.
If you don't use a stop, psychological factors will prevent you from closing a losing trade. The EGO doesn't like to lose. It's true; anyone can observe it when trading.
You always let losses run, hoping to recover them. And this happens often, reinforcing the idea of not using a stop-loss. But with just one trade where the price doesn’t recover, you can kiss all your account money goodbye.
Why? Because on top of letting losses run, you add more positions thinking it has dropped enough and can't drop further. This way, if it goes up, you'll recover the money faster. But it keeps dropping, and losses multiply until the Margin Call arrives.
As I said, it's a shame because we could avoid most losses and always come out victorious if not for that one trade that ruins the entire strategy.
Therefore, it is essential to use a stop, no matter what. One, to calm our psychological fears, and two, to avoid squandering all our money.
Not placing a stop on each of our trades has the following SIDE EFFECTS:
- Total account breakdown: Margin Call.
- No longer being able to trade because we’ve run out of money.
- Much more time than desired without trading, waiting for losses to recover. No liquidity.
- If we don't close the losses, we can't open a more advantageous position, recover those small initial losses, and come out with gains.
On the other hand, PSYCHOLOGICALLY, the effect can be disastrous:
- 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 hopeless...
- Bad mood - Feeling like hitting everything around, snapping at family.
- Sense of helplessness - There’s no way to fix this unless losses recover.
- 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'm losing.
- Isolation - Glued to the screen, ignoring everyone, watching the position every moment, hoping it recovers.
- Insomnia - Checking the stock price at midnight on your phone. Staying awake thinking about the losses.
All of the above escalates incredibly in proportion to the money “at stake.”
So, is it worth placing a stop-loss in every single trade or not?
