Stop-Loss Orders Ease Pain of Bad Market

The severity of the market's decline, which came to a head this fall, reminds us all why the best traders aren't those who can take risk, but those who know how to mitigate it.

For many, 2008 has been a bloodbath. Legendary investor Marty Whitman's Third Avenue Value Fund (TAVFX) is down over 50% year-to-date while Bill Miller's Legg Mason Value Trust (LMVTX) is down more than 60%. Keep in mind these are Plain Jane mutual funds, not the nefarious "unregulated" hedge funds Congress is so dead set on controlling.

* Marty Whitman's Third Avenue Value (TAVFX), Bill Miller's Legg Mason Value Trust (LMVTX) -YTD
Table Source: BigCharts.com

And even in this age of black-box algorithmic trading, the much maligned stop-loss order would've saved many skilled investors from the severe losses they are now nursing.

We go into every investment with the expectation it will perform, but mustn't forget the hubris of a plan in case it doesn't. I don't have price targets, but rather loss limits. Every stock, bond or mutual fund I buy, every investment I make, must have a level at which I'm prepared to take my loss. It could be 15%, 20% or even 25%, but at some point one has to respect the price action enough to get out of the way of a trade that, at least for the time being, isn't working.

A year ago, very few strategists would've predicted that DuPont (DD) would be at $25, Ford Motor (F) would be at a buck and change, or Citigroup (C) would be below $6. Yet even if you had purchased shares of Citigroup at their yearly high of $35.29, a 25% stop would've still gotten you out near $26.50, significantly higher than where the shares are now trading.

Listen to the auto maker CEOs beg, and you'd actually begin to believe that $25 billion would be enough to remedy the problems facing the industry. Keep in mind taxpayers already signed over $25 billion to them a little more than a month ago to build fuel-efficient cars, not that anybody cares now that oil is down roughly 60% from July levels.

Yet if spending money was all it took to remedy a dysfunctional market, we'd be well on our way to Dow 15,000 instead of simply trying to hold onto 8,000. CNBC estimates the government's total expenditure responding to the financial crisis has reached $4.2 trillion dollars -- more than was spent, adjusted for inflation, on the Hoover Dam, the Louisiana Purchase or the Vietnam War. What do we have to show for all that intervention? An S&P 500 index off 45% year-to-date and credit markets that have virtually shut down. Had we only spent $2 trillion, do you think the S&P 500 would be down 90%?

What today's politicians and many CEOs refuse to admit is that intervention doesn't fix a problem, but only prolongs it. As I've been reporting in this space for months, the endless government tinkering has severely disrupted the normal functioning of markets. Bailout dollars, funding facilities, temporary regulations and all that TARP money have made Washington the center of finance more than Wall Street, preventing the normal restructurings, and yes, failures, that are part of any functioning economy. This, not the failure of supposed "free markets," is what has caused credit and equity markets to implode.

There might be enormous bargains in this market. The problem is that, with the inescapable influence of intervention from Uncle Sam, it's near impossible to separate the wheat from the chaff.

Both Sen. John McCain (R., Ariz.) and President-elect Barack Obama have mentioned Warren Buffett as a potential pick for Treasury secretary. Yet even Buffett, who is the default go-to cultural example for the prototypical successful businessman, has been affected by the market maelstrom.

Bloomberg reports that the cost to protect against Berkshire Hathaway (BRK.A) defaulting on its debts with credit-default swaps has more than tripled in the past two months, much as was the case previously with Citigroup, Goldman Sachs (GS) and other large financials.

Shares of Berkshire have slumped sharply, including the biggest drop Wednesday in more than 23 years. A bargain? Not in my book. At least not yet.