Stop-loss orders are popular among many stock market traders and speculators. There are certainly arguments in favor of using stop-loss orders. However, for investors focused on long-term results, I believe they are best avoided.
I share the thesis of fellow contrarian investor and my good friend, Steven Jon Kaplan who believes the stock market is inherently designed to benefit the fewest and punish the maximum number of investors. Furthermore, the stock market, like a virus, adapts and evolves over time to ensure this primary thesis remains true.
For instance, now that technical trading with the use of stop-loss orders has become so popular, the market has adapted to knock these traders out of their trades repeatedly. Even if they have the overall long-term trend of the asset correctly identified, they lose since they're unable to hang in for the win.
Below is an excerpt from Steve's latest True Contrarian newsletter that mentioned stop-loss orders and inspired this blog post. I hope you enjoy it.
"Many institutional investors have a dangerous form of trading bias in which they are looking only at the very short run, without appreciating the consequences of their actions. Some intelligent investors have recognized the blatant overvaluations of extraordinarily popular shares including Tesla (NASDAQ:TSLA), and have been selling them short. However, they may have absurd imposed (or self-imposed) restrictions and/or guidelines where they close out their positions if they are behind by a specific percentage. During any especially extended rally or retreat, many of these short sellers will end up buying back their shares at higher prices because their buy stops are triggered. Similar behavior has occurred on the opposite side with sell stops being frequently hit for the least popular names of the past several months--in many cases causing deeply oversold and undervalued securities to be unloaded very close to their ultimate multi-year bottoms for the entire cycle.
It is interesting to note how other investors are slowly coming around to my opinion about stop losses, which I have discussed several times in past updates and will mention again in the future. In Jack D. Schwager's excellent Market Wizards series of books, the early ones published in 1989 and 1991 featured traders who almost all used sell stops. In his most recent work completed in 2012, fewer than half of the traders interviewed use sell stops, and those who don't have very specific reasons why they don't. Perhaps in another one or two hundred years, shortly after cancer and dementia have been eradicated, it will be understood why stop losses should be relegated along with bloodletting and leeches to practices which were common in the distant past but were found to have only very limited usefulness."
I've been following Steve's newsletter since 2007 and credit him for most of my investment success. I'd highly recommend tuning into his work and tuning out the misleading mainstream media.
Both Steve and I are accepting new clients who are interested in following a proven contrarian investment strategy. Contact me here for more information. I look forward to discussing your investment needs with you.