Stop Losses Are For Pansies

Published in Investing Strategy on 20 May 2010

Volatile markets are triggering many people's stop losses.

Stop losses are for pansies. That's what my Motley Fool editor, in a rare burst of machismo, has told me. This makes me feel bad, because the other day I set up a couple of stop losses on my portfolio, and I was tempted to set up a couple more. In fact, I was tempted to stop loss every single stock I owned (not to mention my income, mortgage, girlfriend...).

I'm clearly in a stop-loss mood. Or maybe I'm just a stop loss kind of guy. If my editor is to be believed, that isn't a very creditable thing to be, even in dangerous times like these.

Perhaps especially in times like these.

I'm not proud. I'd rather be a rich pansy than a broke tough guy. The trouble is that setting up a stop loss does far worse things than impugn your manhood. When I look at how they've worked for me in the past, they have lost me a lot of money as well.

I've never set a stop loss without it being almost instantly triggered. So what does this tell me?

1. I'm setting my stop losses too tightly

Whenever I've used stop losses on my spread bets, I have always plumped for the minimum, to shield myself from a big fat loss. That has spared me from a couple of major blowouts, but it has also stopped me from making big gains, when the stop loss triggered at the first spot of volatility, closing my position and shutting me out from the subsequent rebound. 

Perhaps the stop loss wasn't really the problem. The original bet was bad, not because markets moved against me (it happens), but because I didn't have enough faith in it in the first place.

2. I have an erratic attitude to risk

What's that noise? It's the sound of my latest stop loss being triggered. One of my shares fell 5.7% in this morning's trading. I had set my stop-loss at 10% below its share price, and true to form, it pinged in just a few days. 

It is pretty daft setting a close stop loss on volatile stocks such as this one was, especially in times like these. But my attitude to the stock was also horribly inconsistent. I lost my nerve, as worries over the China property bubble loomed ever larger in my mind. That was when I set the stop loss, with the inevitable result. 

Again, if you have faith in your initial research, you shouldn't need a stop loss. A bit of patience also helps.

3. I don't like making decisions

I've been using stop losses as a substitute for making a sell decision. After sniffing that a stock was in trouble, rather than making the tough decision to offload, I delegated the dirty work to my electronic safety net. 

Like so many things about stop losses, it is good in theory. The stop-loss limit your losses if the share slides, but if it doesn't, you are free to enjoy the subsequent upside. In practice, that has never happened, at least not to me. One reason why may be found in point 1.

4. My strategy isn't clear

Funnily enough, I haven't even thought about setting stop-losses under my emerging markets investment trusts, ETFs or dividend-paying stocks such as Aviva (LSE: AV), Scottish & Southern Energy (LSE: SSE) and Tesco (LSE: TSCO). 

That's because I'm investing in them for the long term, and the last thing I want to do is sell now, with markets sharply down. I now realise I should adopt this strategy with every single stock I buy. 

So no more aggressive short-term bets for me, underpinned (and undermined) by a cowardly stop loss. From now on, it's buy and hold all the way. If you are investing over decades, the best stop loss is time.

So are stop losses for pansies? Who cares? My worry is that all too often, they are for people who don't have faith in what they are doing (often for a good reason). They are unsentimental traps that smoke out short-termism, sloppy thinking and rash decision swings, and for that, I should thank them. But I have no plans to use them for a long time.

More from Harvey Jones:

Harvey owns shares in Aviva, Scottish & Southern Energy and Tesco.

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Comments

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SteveMarkus 20 May 2010 , 7:57am

Good article, and makes a lot of sense. I can think of one contributor who won't agree with you though.

I think you're absolutely right when you say that it is necessary to have confidence in what you are doing. I like to slice my profits when I sense that prices may be nearing a top, or when valuations have got a little ahead of themselves. I did just that two or three weeks ago and consequently have a chunk of cash which I am now able to reinvest at much more advantageous prices. I always make sure that I have sufficient cash available to do this - provided that you have confidence in the companies you are invested in, there is nothing wrong with buying more shares when they're cheaper! It suits me anyway, although as I said above, I know there will be at least one who disagrees (cue Loton....)

Cheers,
Steve.

lotontech 20 May 2010 , 10:05am

Ok, I'll take the bait ;-)

There are two sides to every story; and problems really only occur when first-time Fool visiters assume that the 'official' version of the story must be true.

While I admit that Stop Orders can fool some of the people some of the time, this doesn't mean that they fool all of the people all of the time.

Harvey speaks from a position of knowledge, not ignorance: he's tried Stop Orders, and they don't work for him. I too hope to speak from a position of knowledge, not ignorance: I tried Stop Orders and they didn't work for me either... until I learned 'for myself' how to make them work consistently.

Here's a real-life positive example that I blogged about recently in my Trading Trail:

Investor A (me) bought Allied Irish at 133 and 'stopped out' at 123 for a 'real' loss of (let's keep it simple) £10. Bought back at 115, and when the price fell to 111 I had an additional 'paper' loss of £4. Total banked loss + paper loss = £14.

Investor B bought Allied Irish at 133 and held the position all the way down to 111, for a total 'paper loss' of £22.

At this point, Investor A and Investor B both had open positions and would benefit to exactly the same degree (or not) from any upturn; except that Investor B would always be £8 worse off despite the fact that Investor A took a 'real loss' while Investor B simply held onto his 'paper loss' thinking it was not a real loss.

[Scale up the numbers as appropriate]

Now, on the subject of 'pansies'...

Lifeboats are for pansies; that's why they didn't put enough of them on the Titanic. But the ship's designers had enough faith in their 'research' to know that the ship was unsinkable ;-)

Tony Loton.

afamiii 20 May 2010 , 4:01pm

The decision to use a stop loss emanates from your investment (or trading) system, your personality, AND the amount of times you are available to review your positions in a day, week or month.

I would recommend stop losses for the average amateur investor (who is not going to be watching his stocks more than a few times a week.) For them the stop loss is an insurance policy (that allows them to exit from a position when it is going badly against them and they can not be physically present.)

And with that strategy they should be set with a wide distance from your entry price (or current market price.)

For an average investor between 8% and 12% is probably right for most moderatly traded securities or for a more sophisticated investor at least two to three times the average true range over the past 20 to 40 days.

I assure you if you are stopped out at 8%, you will have the opportunity to reenter once the stock has settled down at somewhere between your initial stop and your original entry price. And the difference between your new entry price and old stop loss is your cost of insurance against a catastrophic loss.

And more likely you will be able to get back in below stop loss (in this case your insurance company paid out.)

The real problem I have with stop losses is that my broker does not support volume contingent stop losses, that are only activated if the volume traded is signficant (though this is only really relevant if you ignore the advice above and put in tight stops.)

dippydoji 20 May 2010 , 4:24pm

I'm new to trading stocks and started out using stops with dreadful result ! I started to increase the stop percentage and still found I had my stops hit. I eventually lost all patience after buying into Spirent on th 5/3/10, setting my stop, only to find on the 19/03/10 the stock dropped, activated my stop, then rose back up again to normal..I understand this is called a 'tree shake'.

With such a well know 'trick' that the market makers seem get away with, why use stops?

I now monitor all my stocks each evening and make the decisions for the next day when the market is closed and I can't panic sell..

bimber 20 May 2010 , 4:27pm

I think setting a stop-loss on the girlfriend is a great idea. Sell at 23, re-enter the market at 19 and ride it back up to 23. Rinse and repeat but don't tell the missus.

rober00 20 May 2010 , 4:56pm

There are two problems with stop losses for investors (I have never felt the need to use them) in my opinion :-

1) they indicate that you are not happy with your stock picking process and the merits of your chosen stocks, which suggests psychologically that you should'nt be buying indivdually chosen stocks ( use Index trackers/Investment trusts and let someone else do the worrying) or that you have not settled on a strategy that works for you (?Harvey).

2) Traders are better at short term trading than you, me or Harvey are and will on average move in and out of the stocks concerned quicker than you stop losses allow.

I know a certain party appears to use them successfuly (no names no pack drill Lotontech!!), but I suspect that he is using a traders mentality/psychology to achieve this whether he thinks he is or not.

Terrapin1 20 May 2010 , 6:21pm

Traders should use stops, investors should not-simples.
I bought my share portfolio in july '99 and watched the whole lot crash, losing over 50%.
If I'd held on until......... about 2065, I might get my money back.
Share prices move because insiders buy and sell them everyone else has to rely on the stopped clock method, whereby you'll be right twice in a decade.

jaizan 20 May 2010 , 9:39pm

Stop losses are simply peverse.

You research a stock. Decide it's good value and then sell it when it becomes even better value? The only reason to sell would be if there is a substantial change in the information available which discredits your original research.
Otherwise, it might be worth buying more.

Jonesey12 24 May 2010 , 12:52pm

Probably too late now, but thanks for your good-natured contribution to this thread, Tony Loton, and I'm sure you're no pansy.

Foolishly yours, Harvey Jones

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