Myth Busting: Stop Losses are a great tool for investors

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One of the best phrases in the market today is a “stop loss.” Think about that . . . who wouldn’t want to stop losing? No one!

However, I will tell you from experience, the only thing a stop loss does is stops you from making money! In fact, I’ve talked with several people in the last week that have experienced the very things I discuss in this email. It’s got me so fired up, it deserves to be this week’s content.

Let’s start with the basics . . .

For those unaware, a stop loss is an order that you can enter with a brokerage saying that you would like to sell a stock (or option) at a certain price. For example, let’s say that you just bought XYZ stock. You’re really excited about the investment BUT you definitely don’t want to lose money after you buy it (who does?). So you put in an order with your brokerage that says, when the stock falls 5 or 10% or when it falls to a certain price, I’m out, sell. The order then automatically sells the stock when it hits that level. You’re out of the position and you move on.

So what’s wrong this?

Everything. Let me give you a recent example.

The market (S&P 500) fell 6% in 20 days (June 8 – June 27). Most stocks during that same time frame fell at least that, if not more. (Some of the markets most popular stocks fell 8 – 10% during that same time).

Let’s say, for example purposes, you had a 5% stop loss on your positions. During that 20-day period you would have been stopped out on most of the stocks in your portfolio.

So what happened?

The market rebounded quickly (as it often does) and went up 4% in 3 days and 7% in 10 days. There is no way, if you would have been using a stop loss, that you would have gotten back in at the precise moment you needed to. You would have lost money.

Really the only thing that you would have done using a stop loss is locked in loss and made the brokerage (think Schwab or TD Ameritrade) money on commissions.

Think about the market we are in right now pre and post-election. The market fell for 9 days in a row, the most consecutive down days in a row since 1980. The market then made it all back in 6 days as the market rebounded.

By using stop losses, you will find yourself in cash at the best most opportune times to be invested. The market, after a normal call it healthy sell-off, typically comes back quickly, so quickly that most people miss it.

So what can you do instead of using a stop loss?

Besides the obvious, stop using them . . . my suggestion would be STOP thinking that you can predict the short term movement of the stock. You can’t. I have never met a person that is successful long term, or even intermediate term, forecasting short term price movement on a stock.

What you should do is truly understand the investment fundamentally that you are buying. Yes, this takes a lot of work, a-lot! It’s harder than just looking at a chart. But if you know the true value of the company, the “intrinsic value” and you’re confident in the companies’ ability to grow over time, then you should just relax and be patient and forget about the market or stock dips. Rather use those dips as an opportunity to buy more.

Bottom line, stop losses are a tool for nervous people that truly don’t believe in the investment they are buying. They are also a tool sold by the brokerages in order to create revenues from commissions.

If you don’t believe you can invest without using this fancy order type, the perhaps you shouldn’t be buying or investing at all?

Here’s to wise investing,

Brett Pattison

What We’re Reading

Icahn Left Trump Victory Party to Bet $1 Billion on Stocks – This is a great example of a contrarian at work. The markets futures, during election night, were down over 4%. It was completely insanity! (for those that don’t know, market futures trade 23 hours a day 5 days a week) What did Carl Icahn do? He went long and bought the market. Genius! In fact, I remember telling my wife (and tweeted this as well), I can’t wait until the morning because the market is being absolutely ridiculous. So what happened? The futures rallied before the open and the market was essentially flat when it did finally open. We were unable to take advantage of it for our clients as we had hoped. . . but Icahn still provided a great example of what to do when the market is acting just dumb.

Value investor Bill Miller says 35-year-old bond bull market is over, stocks should benefit – When Bill Miller speaks, it’s important to listen. While we never know how things will end up for stocks and bonds, we tend to agree with Bill Miller and his point in this article/interview. We don’t subscribe to the 60/40 blended portfolio mumbo-jumbo, as a result we have a lot less of our clients’ money in bonds than most investors. If Bill Miller is correct, which we believe he is, then our clients will be happy with our decision.

Tweet of the Week. This is from Sam Ro is Managing Editor of Yahoo! Finance. He shows the probability that stocks will lose money over certain time frames. This is why our time horizon for our value stocks is 2 – 5 years. You must be patient!

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Categories: Personal Finance and Strategy.