Quit Using Stop-Loss Orders And Let Your Losers Run

Am I out of my investing mind? Any investor with half a brain will tell you to cut your losses short and let your profits run. Using a stop-loss is on par with such advice as buy low and sell high. Investment websites such as Re-Examining the Hidden Costs of the Stop-Loss :

We found that the perceived benefits of the stop-loss were largely balanced out by the hidden costs. As a result there is no inherent edge to be found in stop-losses or profit-taking stops. Furthermore, there is no clear optimal location to place a stop.

Reasons Why a Stop-Loss Can Harm You
Why could this purported risk management tool harm your portfolio returns? Of course, much depends on the specific stocks you are trading but here are some considerations to mull over:

• Stop-losses do not take into account fundamental value

Imagine you owned a utility stock with defensive earnings that can comfortably pay a certain dividend in almost any market condition. The current yield lies around 4%. Then unexpectedly a bear market hits and share prices dive 50%. Should you sell all your stock and buy back later during the bull market? Quite the opposite. Once you look at the fundamental value of the company you realize that now you can buy and essentially lock-in at 8% yields. In this slow moving economy you should absolutely load up on this lower-risk asset generating such a strong return.

The stop-loss only considers technical price action but you should be looking at the underlying fundamentals when trying to determine if you have a boat anchor or an even better deal on your hands.

• Stop-losses leave you open to manipulators

Have you ever seen share prices go up or down for seemingly no reason? Often it can be attributed to a major fund or institution buying or unloading a position quickly. But it might also be a hedge fund short-selling to create weakness in order to accumulate shares. As an example, a firm wants to buy a certain stock at $9.50 despite it trading at $10. So they short-sell the stock which temporarily drives prices down. This price drop kicks in many stop-loss orders and further downward pressure is experienced. At this point the firm switches to buying the high volume of shares that just came available. At the end of the day they have a net positive position at a much lower average price than $10.

• High transaction costs

Down markets are more volatile than up markets. If you sell during a panic drop, you will likely get your order filled at bad price. In extreme examples, think flash crash. In addition to slippage costs you need to consider the trading cost charged by your brokerage. This can quickly erode capital making an otherwise profitable strategy null. These costs are hard to avoid as the lower volume you trade the more expensive the brokerage fees become (relative to your investment capital) and the higher volume you trade the more slippage you are bound to experience.

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Stop-Loss Take Home Message
In today’s volatile market where computer algorithms make up the majority of the trading volume, using stop-losses as a means of limiting risk can be useless or downright risky. It is much more advantageous to consider the value of underlying fundamentals in relation to share price instead of placing an arbitrary sell point based on share price alone. With good stocks you should be buying the dips and not the other way around.

While a stop-loss order below your purchase price seems like common sense, here at Portfolio Cafe we are in the business of making uncommon profits in hedge fund like products for individual investors.