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Smart investing: what we can learn from the past

The father of modern political conservatism, Edmund Burke, viewed history as a great lesson teacher. “Those who don’t know history are destined to repeat it,” he opined.

Mark Twain’s home spun philosophy may have more appeal than Burke’s cold logic. Twain wrote while history may not repeat itself it sure as well does damn near rhymes.

Classic examples of history repeating itself are often military in nature. Think of Hitler’s WW2 invasion of Russia. Napoleon did a similar thing the previous century, and Hitler repeated his mistake. Both suffered the same fate – ultimate defeat.

While it may be too simplistic to draw military parallels with those of the market. Yet they contain the sample simple ingredient – human hubris.

How many investors (including myself) have been guilty of not cutting soon enough a losing stock trade position? It will recover we tell ourselves, when the market bounces. Double up at the low and then get out. Sometimes this works. Often more than not, more good money goes after bad.

And this happens time after time – history repeating itself.

The German’s Operation Barbarasso, military strategists argue, was discipline and targeted using Blitzkreig. Failure on the part of Mussolini’s Italian forces to successfully invade Greece and protect Barbarossa’s southern flank shortened the German offensive time frame by a critical 6 weeks and they ran head first into Russian winter.

The rest is history. Arguably it wasn’t ignoring history that was Hitler’s fatal mistake – Blitzkreig was to take care of that. He failed to adapt to changing circumstances. Mussolini’s hubris about the prowess of Italian gains in the Greece campaign temporarily fooled German High Command. (Greece, Italy, Germany yet again at the centre of current global politics!)

Yet when investors get wrong footed by the market invariably their self justification is something like the stock fundamentals are cheap/the market is wrong/ and true value will assert itself. Usually all are right, but not before the share price continues to fall.

Discipline of the individual, or a market stop loss order is the natural counterpoint to an investor’s investment hubris.

For my money it is one of the hardest things to do – a stop loss order is an admission of getting wrong. It creates self doubt ; I lost money. Where did I make a mistake?

The primary stop loss benefit is it stops you throwing more good money after a bad trade – so it conserves capital. Trading during recent market volatility around the Greek elections, you could have been forgiven for thinking you had lost your marbles. Because it would not have been uncommon to get three or four consecutives trades off on the wrong foot and stopped out.

This, however, it seems is the exception rather than the rule.

I have been guilty of “falling in love” with a stock and bought it during a correction. When I compare outcomes, it would have been better to have had stops in place, rather than ending up a maid servant to market momentum. That wasn’t smart investing.

So what is an appropriate stop loss. Generally rule of thumb, is 10% below a stock purchase price. A margin like this is generally enough buffer to absorb any sudden market conniptions where stocks get sold off during “risk off” in a flight to defensives. If you wish to be more conservative and are sensitive to stock moves, then a 5% stop loss order may be right for you.

It leaves less room for error, and you might find yourself getting stopped out more frequently than having a higher buffer. Your broker might even end becoming your best friend!

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