What If Your Gut Is Wrong?

I got an email last week I was hoping I wouldn’t get.

TradeStops, the service I use to keep track of my stop-losses, sent a message telling me that Albemarle Corp. (NYSE: ALB), which I had recommended in Boom & Bust back in 2016, had closed below the stop-loss I’d specified for readers.

I wrote a quick note the next morning to my subscribers recommending they sell their shares of Albemarle and move on.

Albemarle was a good trade for us, and I have nothing to complain about here. Readers walked away with 50% gains in the stock, even after the recent correction. By any measure, the trade was a success.

But it still hurt me to tell the readers to part with the stock because I just knew the recent selloff was a market overreaction. Nevertheless, I told them to sell. Here’s why…

It’s possible (and probably very likely) that my gut was right and Albemarle’s recent selloff was the result of short-term profit-taking that would quickly run its course. The long-term macro trends supporting the stock were still in place and nothing had fundamentally changed.

But what if my gut was wrong?

As a morality tale of why it’s important to be systematic and not simply trust your gut, consider the case of billionaire hedge fund mogul Bill Ackman of Pershing Square Capital Management.

Ackman made the news this month because he laid off nearly 10% of his staff, including – gasp! – his personal chauffeur.

You know times must be tough when even the driver is getting canned. But that’s what happens when you lack basic risk management. You get burned.

Ackman lost $4 billion betting big – and wrong – on Valeant Pharmaceuticals. At one point in time, Ackman had nearly 20% of his portfolio in that single stock. But because he owned so much of it (and because so much of his identity as a manager had become centered on it) he couldn’t sell when things started to turn south.

From peak to trough, Valeant lost 97% of its value… and Ackman rode it all the way down.

To put that $4 billion loss in context, Ackman’s total assets under management have fluctuated between about $11 billion and $20 billion the past couple years. So, needless to say, that $4 billion loss represented a big piece of his investors’ capital.

Ackman’s cardinal sin was his lack of discipline, and it’s likely he’ll never fully recover from this. Let’s play with the numbers.

Gains and losses aren’t symmetric. If a stock drops 10% on you, a 10% gain won’t get you back to breakeven. You have to earn 11%.

If you lose 50%, you have to earn 100% to get back to breakeven.

And if, like Ackman, you lose 97% on a stock, you’d need 3,233% returns just to get back where you started.

I don’t know about you, but not many stocks in my portfolio return 3,233%, or at least not in a timely manner. This is why it’s absolutely critical that you cut your losses early.

If you’re a good stock picker, you can easily recover from a 10% or even a 20% loss by simply making 11% to 25% on the next trade. That’s doable.

But you’re not going to recover from a 97% loss. That money is gone forever.