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Six ways in which stop losses can damage your wealth

We’ve already looked at the benefits of stop losses in a previous post on Monevator. Please do read that introductory stop loss article if you’re not sure what a stop loss is, or why you might want to employ one.

Personally, I rarely use stop losses nowadays, especially in the guise of an automatic sell orders.

Today’s article will therefore explain the drawbacks to employing stop losses when investing.

I’ll conclude with a few thoughts on resolving the stop loss dilemma.

1. Stop losses guarantee you lose money

This is my most fundamental problem with stop losses.

Say you set a stop loss for 15% on a particular share. If the price falls 14% before rising 50% over a year, you’ll make a great profit. If the price happens to fall 16% before beginning its rise, you’ll miss out completely.

What if you sell out when your stop loss is hit, then review the company again and buy back in, hopefully before the price has risen again?

Here you may benefit from buying at a lower price, but you’ve also got the cost of churn to contend with. Fees and the spread (especially for smaller companies) can really add up if you’re a frequent trader.

2. Small cap shares drift between news

Many private investors who buy shares directly concentrate on smaller companies, since they believe that small caps are more likely to be overlooked by institutional investors, while also offering the potential for greater returns. (See my article on small cap investing for more).

Now, small caps are riskier than large companies – their prices are more volatile, and smaller companies go bust more often – so you might think stop losses would be ideal tools to employ to reduce risk.

The trouble is…

  • The small-cap market trades in much lower volumes than large caps
  • Fewer investment professionals monitor or hold small cap stocks
  • Small cap news flow is very erratic

…which all means small cap share prices frequently drift downwards on absolutely no news whatsoever.

As a result, a stop loss set on small cap share can easily be hit simply because the market got bored between company results, rather than because of any change in trading at the company. Result: you sell out of a good company for no good reason.

If you want to use stop losses to reduce risk when investing in small caps, I suggest:

  • Setting protected stop losses of 20% or more, to try to guard against unexpected bad news while still staying inside the trading/drifting range
  • Review the stop loss in the days ahead of a company’s results
  • If a share price is drifting down, review the company fundamentals then reset the stop loss lower if appropriate

3. Even for large caps, a wide trading range is normal

Big companies are less affected by stop-start share price movements, or general market disinterest. A FTSE 100 company like GlaxoSmithKline has dozens of analysts covering its every sneeze, plus hundreds of sizeable buyers watching the share price like a hawk, which means its prices tend to move up or down a little every day.

But while such large cap shares trade in a more efficient market, they still exhibit great volatility over any particular 12-month period, even in normal, non-bear market conditions.

I can’t currently find specific data for the average trading range of a FTSE 100 company to quote you (if you know of an online resource, please do tell me) but studying any chart over a five-year period shows 20% or more differences between the highs and lows for the year are normal, rather than unusual.

Now, a stop-loss set at 10% may very well protect you from a 20% move downwards over a year, and also from a sudden drop on surprise news, but you’ve also got to realize you could end up selling out simply because you’re following the herd in the market. And if you’re going to follow the herd, why not do it more cheaply by investing in an index fund?

4. Small sellers can spike small cap prices down

Back to small caps. It can be quite astonishing how tiny amounts of shares bought or sold can move a small cap share price. The sale of just a few thousand pounds worth of some small caps can cause market makers to set the price lower.

Even worse is a big holder dribbling out sales of stock for weeks or months on end. If you don’t know what’s going on (and usually you won’t) it can look like all the rats are abandoning a sinking ship, whereas really there’s just one large holder selling down for reasons of his or her own.

You don’t want to sell your shares because somebody fancies a new car or has divorce bills to pay.

5. Stop losses betray a lack of confidence

If you’re investing in individual shares, you presumably believe you have some insight into why that particular company will do better than the market thinks, and why your money is better in that share than in an index fund.

Why then, should you immediately sell your shares just because the market is even less convinced than you and is now only prepared to pay say 90% of what you paid when you thought the shares were a bargain?

Arguably, you should be topping up your investment at cheaper prices – the Warren Buffett approach to buying companies.

This thinking is most applicable to value investors. In contrast, those buying the shares of small-cap growth companies often fear that a price fall indicates insider or better informed knowledge leading to selling ahead of disappointing news.

With value shares, prices are often so knocked-down that bad news is already expected. But with a growth share, even a mild earnings downgrade or slightly weaker margins can hammer the share’s attractiveness.

I can’t give a precise rule here, but I’d be much more likely to set a stop loss if investing in a highly-rated small cap growth share than a value share.

6. Cheap shares often get cheaper

If you’re buying shares according to the Benjamin Graham school of value investing (which arguably has the best record over the long-term of all active trading strategies), then you’ll spend a lot of time researching and holding the stocks of unloved companies.

Let’s say you find a widget manufacturer that you consider to be a bargain. You stick two fingers up at the market and its bad opinion of the company, and buy yourself £2,000 of Widgets-R-Us.

Well, guess what? The market couldn’t care less about your £2,000. Just because you’ve alighted on value, it doesn’t mean anyone else has spotted it yet. The share is very likely to stay in the doldrums, or even fall lower, after you buy.

As a value investor, you’ll therefore spend a lot of time buying shares that nobody wants. Such a contrarian attitude is simply not compatible with getting automatically stopped out because the market takes a bargain basement price down another 10%.

Provided the fundamental story and numbers that attracted you to the company remain in place, you should keep holding value shares until either the value is realized, or until you (not the market!) see your mistake and sell out at a time and price of your own choosing.

Concluding thoughts on stop losses

I’m well aware this article reads like a classic flip-flop investing article with no hard takeaway rules. Unfortunately, that’s exactly the nature of investing directly in the stock market. (It’s meant to be impossible to beat the market, remember?)

Personally, I think writing down a stop loss price in a notebook or log is a good idea. If the price falls to hit it, consider that a reminder to re-examine the fundamentals of the company and decide whether the story has changed and whether you should sell the shares.

This method won’t protect you from sharp falls downwards, but it will prevent you being stopped out for the various dumb reasons listed above.

If you want to be more cautious, consider setting a temporary stop loss ahead of company results. Remember though that prices often fall suddenly on results day, as investors consider it better to travel than to arrive. I’d probably therefore only do it if I was very nervous about the company’s trading outlook.

If you’re a short-term trader, capital preservation and running winning positions is all, and you should certainly use stop losses.

That’s not my chosen way to invest, however. As a longer-term investor, stop losses cause me as many problems as they solve, so I consider them a very optional extra.

Carefully sizing positions to reduce the potential losses from any particular share going wrong and proper portfolio diversification are more appealing ways for long-term investors to reduce risk, in my opinion.

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