The Pros and Cons of Using Stop Losses

As an individual, I feel it is important to have an exit criteria as nobody knows when a really severe fall is going to occur from which it may take years rather than months to recover. Some individuals may be prepared to accept this, though I imagine they are in the minority.

Monty Burns invested in top hats

It is also funny how this question regularly comes to light when the stock markets are declining or suffering from some temporary problem and, since as far as I have noticed, the stop loss issue seldom seems to be aired when markets are going from strength to strength. I find this interesting as a stop loss is most useful in a rising market, where the stop loss can focus on sector and stock risk rather than market risk.

Every investor, I would imagine, at some stage makes errors of judgment along the way and makes poor investment choices. Unless an investor operates some kind of exit strategy he risks tolerable losses becoming intolerable. If a share loses 50% of its share price it basically then needs to double in price in order to recoup the original investment. There are many shares which will drop by this amount and still be worth holding if a long term view is held. The share that loses 90% of its share price, in most cases, will be a different prospect. It would then require to increase ten-fold in order to reach the break-even point. I can see little point in holding on to such a share other than as a tax write off or as a reminder of a stupid past decision not to be repeated.

Granted, you can become a great investor without ever selling a single share. I am reminded of the Simpsons episode where Monty Burns invested in top hats and something else. Only to find they no longer exist. However, Warren Buffett is a good example of someone who often just holds and holds and holds. Even Buffett made mistakes though, if my memory serves me right, and though he mainly holds and holds he is prepared to accept his failures. But the point here is to worry less about capital gain and more on income gain (which is sometimes seriously overlooked by investors). Dividend return, particularly where it is steadily increasing is not to be ignored.

This is not to say that stop losses don't have flaws and it is important to recognize their limitations some of which are -:

  1. Exit criteria should in my opinion never be based on a falling price alone, however a falling share price may be an indicator of fundamental issues, and thus worthy of investigation.
  2. Presuming you always want to be fully invested, market risk is a considerable part of the highs and falls of a share. Thus to sell because the price is falling does not make sense, as you will still continue to have that same risk in any other share that you purchase with the stop loss proceeds. Therefore it might be more relevant to set a stop loss in relation to a sector, or market.
  3. A stop loss also places too much emphasis on capital return rather than income return. Yet history shows that income return is as relevant. Ask yourself, why would you sell after a 20% drop in share price, but not necessarily after a 20% drop in EPS (such companies include this year Vodafone, British Land, Severn Trent, Vedanta) .
  4. Also, it highlights only an awareness of your losses. Would you buy a share that was more than 20% off its highs? If so, then are you just buying someone else's stop loss. Why is this any better a strategy than holding after it drops 20% rather than selling?
  5. I could go on and on - in fact I've written another article on the limitations of stop losses here.

However, no one can deny that stop losses are useful in that they take the emotion out of selling. This is a definite advantage especially as people invest in success and run away from failure. You can still go against your pre-defined exit criteria and decide to hold but you will be consciously doing so. If nothing else, this forces you to examine your own investment psychology, forces you to think and, as a result, helps you to learn. In fact this is quite an interesting one, because we apply emotion in buying as well and I don't know why emotion is often not perceived as a problem in that activity. It may be worth considering pre-defined entry criteria as well as exit. Far too often, as investors, purchases are made at what are regarded as reasonable prices, rather than employ a suitable margin of safety and buying at a discount. Why do we do this so often? Personally I believe that we delude ourselves into believing that we are missing out on an opportunity and are greedy to grab that chance rather than have the patience to await a better entry point.

One of the greatest benefits - you can consider stop losses as an extra cost which you absorb to allow for the lack of time to analyze.

The psychology of investing is a fascinating subject where a lot of interesting material has been published and so many of our opinions touch on this but another topic which could be discussed for a long, long time.


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