Almost every professional advisor recommends using stop-loss orders in every single position. They claim that investors run the risk of facing devastating losses if they do not use a stop-loss order. However, in this article, I will analyze why this strategy is likely to result in very poor returns.
First of all, the purpose of using stop-loss orders is to cut the losses from a declining stock early enough in order to protect the value of the portfolio. When the stock corrects by the amount set by the shareholder, the stock is automatically sold. However, investors who use this strategy should realize that they essentially sell low and buy high.
Moreover, during the ongoing 8-year bull market, the S&P 500 (NYSEARCA:SPY) has corrected several times but all these corrections proved short-lived, as the market rebounded sooner or later and is now trading at an all-time high. Therefore, all those corrections were great times to purchase stocks, not sell. Those who sold their stocks were left on the sidelines and missed one of the greatest bull markets in history. Some investors did not bear the emotional pressure of missing the train and thus repurchased their shares at much higher prices than their exit points. Hence they sold low and bought high. This is certainly not a viable long-term strategy.
Even the major crashes, such as the crash of 1987 and the flash-crash in 2010, proved short-lived. Those were the most opportune times to purchase stocks instead of selling them. As the long-term trend of the market has always been upward, investors should view corrections as opportunities to purchase solid stocks, with promising growth prospects and minimum debt. They should not view corrections as the right time to unload their holdings.
For instance, only during the last 5 years, Altria (NYSE:MO) has corrected by at least 10% on 5 occasions. Those who set a stop-loss order about 10% lower than the prevailing stock price sold their shares and missed the exceptional returns that the stock offered later. To be sure, the stock has rallied 133% in 5 years without even taking its generous dividends into account. If one owns such an exceptional stock, one does not have any reason to apply stop-loss orders.
The reason that some investors insist so much on having stop-losses is that they do not do their homework in the first place; i.e., they choose stocks with a business model that is too volatile and vulnerable. If the homework is done properly in the phase of stock picking, there is no need to use stop-losses.
Investors should also take into account the increased commissions and fees that result from the frequent use of stop-loss orders. As these costs are low in the short term, they are usually ignored by investors. However, they tend to accumulate pretty fast and hence they pose a significant burden on the long-term returns of a portfolio.
Nevertheless, it is too risky to keep holding a stock whose value plunges without taking any action. Therefore, when a stock incurs a significant correction, down to the point at which a stop-loss would be placed, investors should not sit idle. They should perform their due diligence in order to determine the cause of the correction. If the stock has corrected due to a broad market sell-off, then investors should hold the stock. If the correction has resulted from a non-recurring headwind, again they should hold the stock. Only if the correction has resulted from permanent business deterioration should they consider selling the stock.
Therefore, while I recommend avoiding stop-loss orders, this does not mean that investors should completely ignore the prices of their stocks. If their stocks plunge, investors should make the effort to identify the cause of the plunge. As soon as they determine the cause, they should act as per the above guidelines. Of course, it is not always easy to determine whether a headwind is recurring or non-recurring, but this is actually the greatest challenge in investing. Selling a stock regardless of the cause of its correction is essentially equivalent to assuming that all the headwinds are recurring and causing permanent business deterioration. However, experience has shown that the opposite is true in most cases, at least in the cases of solid stocks with a strong record. Therefore, selling regardless of the cause is not a sound investing strategy.
To sum up, the use of stop-losses is a sell-low-buy-high strategy, which attributes much more significance to the market gyrations than it should. As the vast majority of market corrections have proved short-lived, the users of stop-losses run the risk of missing a great bull market, just like the ongoing one. On the other hand, investors should not completely ignore the price behavior of their stocks. If a stock incurs a significant correction, investors should perform their due diligence, determine the cause of the correction and then decide whether they should sell or keep the stock. In other words, they should decide on their own whether they should keep the stock and not let the market fluctuations decide for them.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.