Buying a stock is one thing, but when do you sell? That question will have been nagging many nervous investors in recent months, after watching global stock markets tumble. One potential solution is to use stop-loss orders that ensure you exit your position when the price falls below a designated point. Do stop-loss orders work? Can they help investors sleep better at night by cutting back on risk? Or are stops a trader’s tool, best left to those who nip in and out of markets rather than investors with multiyear horizons? In the past, an investor might have instructed their broker to sell if the price of a security fell below a certain level. These days, stop-loss orders are easily set up via online trading platforms. For example, an investor who buys a stock at, say, €10, might set up a stop order so that his position is automatically closed if the price falls below, say, €9, thus hopefully ensuring their potential losses won’t exceed 10 per cent.
Alternatively, if they feel the stock needs more wiggle room, they might decide the stop order will only be triggered if the price falls below, say, €8.
Other traders are opposed to stops being positioned at random price points. Instead, they might place their stop below a technical price point – for example, a price point that has acted as a technical support level in the past, or a stock’s 200-day moving average, or some such level.
Three benefits
The potential benefits of stops are threefold. First, they are a risk management tool designed to cut losses before they get out of hand. In hindsight,
Sean Quinn
must regret he didn’t use stops to limit his losses in Anglo-Irish Bank shares in 2008-2009. Instead, he kept on buying as the share price fell, a decision that cost him billions.
Unlike Anglo, most stocks don't go to zero, but bear markets can cause severe losses. The Nasdaq fell by almost 80 per cent from its dotcom-era peak in 2000; household names like Cisco and Amazon suffered even larger losses during that period. The S&P 500 more than halved during the global financial crisis, while the Iseq fell by more than 80 per cent.
Today, many investors are again worried unpleasant losses may lie in store for stocks, given that valuations look elevated following the second-longest bull market of all time. Second, stops offer peace of mind. The “‘when should I sell?” question can be a tortuous one, and nervously monitoring the share price on a daily basis is not a recipe for mental wellbeing. In contrast, stop orders take some of the emotion out of the decision-making process. Third, some investors use stop orders to protect their profits. As their position rises in price, they may adjust their stop order upwards, thereby heeding the old dictum that you should cut your losses but let your winners run.
Some cons
There are also cons associated with stop-loss orders, however. First, there is no guarantee you will get out at the price you specified. To return to the aforementioned example where an investor buys a stock at €10 and places a stop order at €9: extremely negative news could cause the stock to plummet in overnight trading. By the time the market opens for trading the next day, the stock may have gapped down to, say, €6 – far below your specified price point. Second, more stop orders mean more trades and higher transaction costs. Stop-loss orders can also be psychologically difficult – you may be stopped out of your position only to watch the stock rebound in price, resulting in you selling at the bottom and buying back in at a higher price point. Finally, most advisers agree that investors should take a long-term approach and not be swayed by short-term volatility. Stocks have experienced five separate double-digit corrections since the current bull market began in March 2009. Investors who gritted their teeth and held tight have more than quadrupled their money during that time.
As for risk-averse investors who don’t want to witness too much volatility, they can always dial back on risk by reducing their equity allocations and holding bonds and cash. Still, it’s not true to say that stops are purely a trader’s tool. Some long-term investors rely on trend-following systems that aim to keep them invested for the bulk of bull markets while being out of equities for the bulk of bear markets. You will never buy at the bottom or sell at the top with such systems, but nor will you suffer the kind of excruciating drawdowns associated with especially severe bear markets.
Research findings
What does the research say? Tight stop-loss strategies – that is, stop orders designed to minimise losses by getting out close to the purchase price – are a bad idea, according to research conducted by quantitative expert
Andrew Lo
, an economics professor at MIT.
Stops do reduce volatility, but the benefits tend to be cancelled out by the fact that investors often miss out on gains after being prematurely stopped out of positions, according to the authors of a 2008 paper, Re-examining the Hidden Costs of the Stop-Loss.
Unsurprisingly, it found stops reduce returns during bull markets by missing rebounds following short-lived corrections, but they enhance returns during bear markets by avoiding further losses. In other words, "a trader who can predict the future price trend may reliably benefit from stop losses", to quote the summary of the paper offered by the CXO Advisory website. That's a big 'if', of course, but the academic literature regarding stop-loss orders is quite supportive of their use. Another Andrew Lo paper, When Do Stop-Loss Rules Stop Losses?, examined the performance of a simple stop-loss strategy – sell US equities after a 10 per cent fall and invest in bonds, only buying back into stocks after the 10 per cent stock market fall had been recovered – over a 54-year period. This simple, almost crude strategy worked very well, outperforming a buy-and-hold portfolio over the same period.
Difficult environments
Promising results were also reported in a 2013 study conducted by German money manager Joachim Klement, which examined the performance of stop-loss strategies in six different global equity markets as well as for property investments, a commodity index and gold. Stop-loss rules "significantly reduce volatility and excessive losses", although results are "mixed" for investors seeking better returns. Stop orders increased returns "for most equity markets and listed real estate but not for commodity indices or gold", according to Klement.
Like earlier studies, he found “significant differences” between bull and near markets; stop strategies usually outperform in difficult environments and underperform in bullish climates.
The problem, perhaps, is that there is “no single rule of thumb for determining which stop-loss and re-entry thresholds provide the best results for all asset classes”. What worked in one market may not work in another, just as what worked in the past may not work in the future. Stop-loss orders, perhaps, are best utilised by experienced investors who appreciate there are no guarantees in markets. Stock market investing can be an unnerving business; while stops may help reduce risk, there is, alas, no sure-fire way of avoiding sleepless nights.
