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August 14, 2019 / 7:47 PM / a month ago

Stop Using Stop-Loss Orders… They Don’t Work!

Trying to stop losses is an undeniably reasonable impulse, regardless of your investing goals. Unfortunately, stop-loss orders, despite the name, don’t reliably accomplish what they set out to do in our view. In fact, you are likely to lose money with stop-losses. They can also just as easily stop future gains, incur transaction fees, trigger taxable events and otherwise cause you to make less money than if you simply let your investments be. Given this list of unintended and undesirable consequences, it would be more accurate to rename these “stop-gains.” Trying to stop losses is an undeniably reasonable impulse, regardless of your investing goals. Unfortunately, stop-loss orders, despite the name, don’t reliably accomplish what they set out to do in our view. In fact, you are likely to lose money with stop-losses. They can also just as easily stop future gains, incur transaction fees, trigger taxable events and otherwise cause you to make less money than if you simply let your investments be. Given this list of unintended and undesirable consequences, it would be more accurate to rename these “stop-gains.” 

Before we examine why they tend to lead to bad outcomes, let’s take a look at how stop-loss orders work. 

Stop-loss Orders

A stop-loss is an outstanding order placed in advance to automatically sell a position—whether it’s a stock, bond, exchange-traded fund (ETF), or mutual fund—when it reaches a specified level. When the position reaches that specified level, whether it has fallen or risen in price, your stop-loss order automatically kicks in. 

There are two main types of stop-loss orders. 

A stop-loss market order gets filled at the next available price. For example, if you set your stop-loss order for $50 per share—say a 20% decline from your purchase price—when the stock hits $50 your order will be filled at whatever price the stock is currently trading. Sometimes this can lead to a sale price substantially lower than the price at which your stop-loss order is triggered due to dramatic intraday fluctuations in the stock’s price.  

You may be able to avoid this problem with a stop-loss limit order. With a stop-loss limit order you set a sale price. If your order cannot be filled at this specific price, no sale will occur.

At first glance, stop-loss orders may seem like a straightforward way to minimize losses and volatility. Further, having an automated sell strategy can seem disciplined, a way to take emotion out of the calculus. But if stop-loss orders really were reliably effective, every professional money manager would use them. As far as we are aware, no perennially outstanding money managers regularly use stop-loss orders. 

Stocks Aren’t Serially Correlated

The principal reason stop-loss orders don’t work is because stock prices aren’t serially correlated. This means that what happened yesterday or last month does not necessarily affect what will happen today, tomorrow or next month. Past price movements of stocks do not determine future price movements.

Stop losses, and the related school of thought called momentum investing, assume that price movements are predictive—contrary to a vast body of research and scads of empirical data. Momentum investors tend to buy stocks as they are going up and sell them as they are declining in value—trying to capitalize on the trend continuing. However, this can lead to buying high and selling low—exactly the opposite of what you want to do! While there are many famous value investors, you’d likely have a hard time naming a famous momentum investor off the top of your head. Quite simply, this is because it is not an effective long-term investing strategy in our view. 

Arbitrary Levels 

Another problem with stop-losses is they force you to choose an arbitrary level or price at which to sell your stock. Say you choose to sell if a stock drops more than 20%. Corrections—common features of heathy bull markets—are quick, sentiment driven drops of up to and sometimes more than 20%. However, markets tend to recover quickly from corrections, so if you sell out after the 20% decline you may miss a substantial portion of that steep recovery. In this same scenario, even though the stock has declined 20%, it has about a 50-50 chance of continuing to drop or reversing course and rising. A stop-loss order would essentially be trading on a coin flip—not a good bet!

Exhibit 1: Stop-Losses—Trading on a Coin Flip
Note: For illustrative purposes only. Not to be interpreted as a forecast.

 

To illustrate the arbitrary nature of stop losses, consider this scenario: Jen buys ABC stock at $50 and it rises to $100. Then Sam buys ABC at $100, and it falls to $80—a 20% drop from its high. Should they both sell at $80? Or just Sam because he has a 20% loss? Based on this scant information, there is no right answer because past price movement isn’t indicative of future price movement. To illustrate the arbitrary nature of stop losses, consider this scenario: Jen buys ABC stock at $50 and it rises to $100. Then Sam buys ABC at $100, and it falls to $80—a 20% drop from its high. Should they both sell at $80? Or just Sam because he has a 20% loss? Based on this scant information, there is no right answer because past price movement isn’t indicative of future price movement. 

Increased Transaction Costs

By choosing arbitrary levels at which to sell stocks, stop-losses can distract you from market fundamentals. Instead of making investing decisions based on underlying economic fundamentals, you might end up selling during a temporary bull market downturn—a terrible time to sell. Stop-losses can also create a false sense of security by making it seem possible to limit volatility and losses without having to closely monitor your portfolio. 

Unfortunately, the only certainties with stop-losses are increased transaction costs and locked-in losses. You may end up selling a declining stock and then buying that same stock back after it has increased in price. Of course, you’ll end up paying a commission on both of these transactions even if your strategy didn’t work out as intended. So, we suggest you stop using stop-loss orders and instead make your investing decisions based on economic fundamentals and your market outlook.

Investing in stock markets involves the risk of loss and there is no guarantee that all or any capital invested will be repaid. Past performance is no guarantee of future returns. International currency fluctuations may result in a higher or lower investment return.  This document constitutes the general views of Fisher Investments and should not be regarded as personalized investment or tax advice or as a representation of its performance or that of its clients. No assurances are made that Fisher Investments will continue to hold these views, which may change at any time based on new information, analysis or reconsideration. In addition, no assurances are made regarding the accuracy of any forecast made herein. Not all past forecasts have been, nor future forecasts will be, as accurate as any contained herein.

The Reuters editorial and news staff had no role in the production of this content. It was created by Reuters Plus, part of the commercial advertising group. To work with Reuters Plus, contact us here.

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