Stop-Losses Aren't Your Salvation

Consider these other potential pitfalls:

Using stop-losses results in decision-making asymmetry. You should seek symmetry in your buying and selling decision-making process. You can't buy because you like the long-term fundamentals, such as management, price, value and competitive position, and then sell because of nonfundamental factors, like a 10% price decline. Buying and selling decisions should be based on the same underlying thought process; in my case, all decisions are fundamentally based. The fact that a stock goes down or up by 10% after I buy it is irrelevant because I'm confident in my estimate of its long-term value.

Stop-losses are a form of insurance. Maybe you use a stop-loss as insurance in case you missed something in your fundamental analysis. It can add up to a fairly pricey policy, if you factor in trading costs and slippage. The better -- and cheaper -- form of insurance is simply to raise your buying criteria. If you spend more time getting the fundamentals right in the first place, then the extra insurance cost of a stop-loss is unnecessary.

Don't chase tails. You shouldn't allocate capital to a stock unless you think it's a compelling value. If you thought a stock was a compelling value when you bought it, then why sell it after it declines 10%? If you use stop-losses this way, you're simply chasing the tails of other investors. Assume that you'll never buy at the low and that a stock will decline over the short term after you buy it.

Stop-losses are arbitrary. There's nothing magical about a stop-loss point. Are you willing to accept a 10% price decline? Why not 12% or 15%? Whether you draw a line at 10% or 30%, it's still an arbitrary one.

Consider a Double-Up Strategy

The next time one of your holdings gets clocked, despite the fact that you've done your homework and nailed the fundamental story, consider the opposite of a stop-loss strategy. Think about doubling up on the position, something I've done successfully in The Turnaround Report portfolio.

Your second buy lowers the average cost basis for the total position. If you're right on the position -- that it's undervalued -- you'll end up making volatility your friend. And to the extent that you buy more shares at a price demonstrably lower than the company's underlying business value, your margin of safety is wider.

Friday Q&A

Look for my regular Q&A column this Friday, where I'll be answering your "off-the-wall" questions. On the following Fridays, I'll be taking your questions on specific stocks that you think are extremely undervalued (Aug. 8) and overvalued (Aug. 15). Send me an email if you have a question for me.

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Arne Alsin is the founder and principal of Alsin Capital Management, an Oregon-based investment advisor and portfolio manager of The Turnaround Fund, a no-load mutual fund. At time of publication, neither Alsin nor ACM held a position in any securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Alsin appreciates your feedback and invites you to send it to [e-mail]. Click here to receive Arne's latest favorite stock picks from his newsletter, The Turnaround Report.