Stop loss – stopping or locking in losses?

A reader recently submitted a series of questions. They wanted to understand the stop loss function that you can activate through your broker.

Some brokers offer their clients the option to place a stop loss order on a holding. The purpose of a stop loss order is to let the investor specify a share or unit price that they would want their investment automatically sold at. It is intended to be a risk management tool to protect an investor against significant losses.

For example, if you bought a share at $60, and you set a stop loss at $20, the broker will automatically sell your holdings if the price falls to $20. While not ideal at least you saved part of your capital, right? The alternative argument is that you just locked in your losses. An investor would use this functionality as a risk management tool. They would set an order to limit the loss on a certain position at a specified level. For a position that has appreciated the stop loss order could be used at a price above the purchase price.

There are several reasons I would not use a stop loss order in my own portfolio. I will outline my thoughts and then get to some specific questions from the reader.

Price and value are not synonymous

The first is that a drop in the price of an asset isn’t always indicative of the value of the asset. In fact, most of the time it is due to market volatility rather than a reflection on the value of the asset. If price and value were always the same there would be no point in investing in individual shares. To accept that there are sometimes large variations between price and value means a stop loss order could automatically sell a share for far less than it is worth. That is not a formula for investing success.

Does the original thesis for your investment still stand?

When you buy a share or ETF it should be because you have a thesis as to why this particular investment is attractive and will help you achieve your goals. This thesis should not be that you want the price to go up. That is the ultimate outcome you desire but the thesis should explain why you think the price will go up. Having a thesis about ‘why’ something will happen is what separates an investor from a speculator.

Price movements over the short-term may not relate to the validity of your long-term thesis. Personally, I’m much more comfortable reassessing my thesis than having an automatically triggered sale based on price movements.

Are price movements the only thing that matters?

They are not. Some investors are trying to generate income from their portfolios and a stop loss order would lower the amount of income generated by a portfolio. A share holding with a safe and growing dividend could be sold automatically based on price movements.

Some investors are simply trying to beat the market which means a stop-loss order selling a position at a 5% loss would seem counterproductive if the market had fallen 10%.

Reader questions:

Is there a difference when applying stop losses to Australian shares, overseas shares or ETFs?

Technically there isn’t a difference as in each case the investor would define a price that the share or ETF would automatically be sold. For an overseas share, because the stop loss order would be in the local currency of the share, that wouldn’t necessarily protect you from losses in Australian dollars. If the local currency appreciated against the currency the share was trading in you could experience losses without the stop loss order being triggered.

In the case of an unhedged ETF that is investing in foreign shares the stop loss order could be triggered because of currency differences rather than movements in the underlying shares. This would still be a loss for you as an investor but the driver of that loss would be currency changes. Something to keep in mind.

The consequences of an unintentional stop loss execution

The first is transaction costs. You’ll pay brokerage on the way out, and if you wanted to get back into the market you would pay it on the way in. You’d also cop buy/sell spread.

The second is potential tax. If your investment has appreciated and your stop loss is above your cost basis, you will incur tax for the sale. If it is a capital loss, you may be able to net this against capital gains for the year – but this forces your hand. You will still have to sell an asset to incur capital gains, and you miss the opportunity to strategically time this to improve your net outcomes.

The third is behavioural. It is hard enough staying invested. It is even harder to get back invested in a volatile market. If a stop loss is executed, it is likely you’re in stormy seas. Having your investments sold, and realising a large drop in the value of your holding is not really incentive to get invested back in the market. Depending on the type of investor you are, you may sit out the volatility and wait to get back invested at a later date. Over the last 30 years, if you missed the S&P 500's 10 best days, your return would be cut in half. If you missed the best 30 days over the last 30 years, your return would be 83% lower. 78% of the best days occurred in a bear market. Regardless of whether it is short-term volatility or your in the midst of a bear market, it is folly to think that you are able to time the rise in markets. It’s a pure gamble, and you’re likely to miss out on some of those days that make up the majority of returns.

Lastly – there is slippage. It is likely that your stop loss has been executed at a time where there is security specific or market volatility. Meaning – the price will be moving rapidly. The price that your trade is executed may be different to the stop loss price that you entered into because of market liquidity. You may end up disappointed with the price that you receive.

Is there a place for stop-loss orders?

As long-term investors, we exchange short-term volatility for higher expected long-term returns. It is normal to feel anxious during volatility but to be successful we need to limit the poor behaviour of selling low and buying high. It is very easy to engage with a function like stop-loss. It takes the pain away and ensures that you at least maintain some of your capital. If you use it to lock in a loss or a gain you are potentially giving away long-term success to feel better over the short-term. I see these as tools for traders. I prefer to focus on the long-term. I only sell my investments as part of a thought-out process that considers my financial goals, instead of a knee-jerk reaction.