The Truth About Investing Using Stop Losses

22 Jan

The Truth About Investing Using Stop Losses

One of the best phrases in the market today is a “stop loss.” Think about it…who wouldn’t want to stop losing? No one! However, I will tell you from experience, the only thing a stop loss does is stop you from making money! In fact, I’ve talked with several people in the last week who have experienced the very things I discuss in this email. It’s got me so fired up, it deserves to be this week’s content.

Let’s start with the basics.

For those unaware, a stop loss is an order that you can enter with a brokerage saying that you would like to sell a stock (or option) at a certain price. For example, let’s say you just bought XYZ stock. You’re really excited about the investment, but you definitely don’t want to lose money after you buy it (who does?). So you put in an order with your brokerage that says, “when the stock falls 5% or 10%, or when it falls to a certain price, I’m out, sell.” The order then automatically sells the stock when it hits that level. You’re out of the position and you move on.

So What’s Wrong With Stop Losses?

Everything. Let me give you a recent example. The market (S&P 500) fell 6% in 20 days (June 8 – June 27). Most stocks during that same time frame fell at least that, if not more. (Some of the market’s most popular stocks fell 8–10% during that same time.)

Let’s say, for example, you had a 5% stop loss on your positions. During that 20-day period you would have been stopped out on most of the stocks in your portfolio. (For related reading, see: Forget the Stop, You’ve Got Options.)

What happened next?  The market rebounded quickly (as it often does) and went up 4% in three days and 7% in 10 days. There is no way, if you would have been using a stop loss, that you would have gotten back in at the precise moment you needed to. You would have lost money. Really the only thing that you would have done using a stop loss is locked in the loss and made the brokerage (think Schwab or TD Ameritrade) money on commissions.

Think about the market we are in right now pre- and post-election. The market fell for nine days in a row, the most consecutive down days in a row since 1980. The market then made it all back in six days as the market rebounded. By using stop losses, you will find yourself cashing in at the most opportune times to be invested. The market, after a normal, healthy sell-off typically comes back quickly, so quickly that most people miss it.

So What Can You Do Instead of Using a Stop Loss?

Besides the obvious, stop using them, my suggestion would be to stop thinking you can predict the short-term movement of the stock. You can’t. I have never met a person who was successful long-term, or even intermediate-term, at forecasting short-term price movement on a stock. (For related reading, see: Profit Without Predicting the Market.)

What you should do is truly understand the investment fundamentally that you are buying. Yes, this takes a lot of work. It’s harder than just looking at a chart. But if you know the true value of the company, the intrinsic value, and you’re confident in the company’s ability to grow over time, then you should just relax and be patient and forget about the market or stock dips. Rather, use those dips as an opportunity to buy more.

Bottom line, stop losses are a tool for nervous people who truly don’t believe in the investment they are buying. They are also a tool sold by the brokerages in order to create revenues from commissions. If you don’t believe you can invest without using this fancy order type, then perhaps you shouldn’t be buying or investing at all.

Write a Reply or Comment