Do Stop-Losses Reduce Investment Risk?

Do Stop-Losses Reduce Investment Risk?

Stocks are among the most volatile of the many types of publicly-traded investments available to the public.  Whether you invest in stocks directly or through mutual funds or exchange-traded funds (ETFs), you might feel more comfortable with your investments if you knew you could limit your losses in case the market or the particular company were to suddenly take a hit.  One of the simplest ways to do that is through a stop-loss order, which allows you to specify in advance a price at which you’d automatically like to sell your stock or ETF if its current price should fall to that level.  (Stop-losses are not available for mutual funds.)  But they have their side effects as well.  Are stop-losses worth using or not?

Let’s start with individual stocks.  Suppose you buy 100 shares of Apple stock at $100.  Although you expect the company to do well (you wouldn’t have bought the stock if you didn’t think so), you are worried that a lower-cost smartphone competitor could enter the market and cause lots of problems for the company.  So you ask your broker to put in a stop-loss order to sell 100 shares of Apple stock for $90.  By doing so you would be limiting your losses in your Apple investment to 10%.  If the stock price continues to go up, the stop loss will never be executed.  But if something should happen to cause the price to drop to or below $90, your stock will be sold automatically.

You can do the same thing with ETFs.  You can buy 100 shares of the SPDR S&P 5000 ETF for $200, for example, and put in a stop-loss for $180.  If the broader U.S. large cap stock market (as tracked by the S&P 500) were to drop by more than 10%, your holding would be sold.  In that case you would be protecting yourself against a broader market decline rather than against the fortunes of an individual company.

It sounds like a no-brainer to utilize stop-losses.  But not so fast.  It’s important to understand the details.  First, a stop-loss order is only good for up to 60 days, after which it expires.  You’ve lost your protection if you fail to remember to put in another one after that time.  In addition, the stop-loss does not guarantee the price at which your stock will be sold.  It simply executes a market order to sell your stock when the price reaches the stop-loss price.  For example, if Apple’s stock price was plunging due to some severe negative news about the company, and your stop-loss triggered at $90, by the time your sell order is placed the stock price could have dropped to $85 or even lower.  So you might end up with a bigger loss than you had anticipated.  While such rapid price declines are uncommon, they do happen.

Another common problem with stop-losses is making them too narrow.  If the price of the stock or ETF normally fluctuates by 10% or more in a given month or quarter, then a 10% stop-loss will likely result in the premature sale of the holding whenever there’s a short-term downward spike in the market.  By selling your stock or ETF on the spike you’d miss out on all the gains afterwards.

Frequent readers of this column will know that I do not recommend individual stocks to my clients.  In my view that’s simply adding on too much risk to a portfolio.   But if you like to invest in stocks for whatever reasons, stop-losses can be a good way to help you manage that risk, especially if you are not monitoring the prices on a regular basis.

What about utilizing stop-losses for ETFs?  Simply put, I recommend against them.  That’s because the purpose of ETFs (as well as mutual funds) is to create and maintain a well-diversified portfolio.  When the value of an ETF drops it is a reflection of a decline in its asset class.  It would be foolish to completely sell out of that asset class simply because it has declined in value.  The better way to address such an occurrence is to rebalance your portfolio periodically and/or to utilize ETFs or funds that are structured to manage volatility and risk in other ways.  And if a stop-loss were to trigger an ETF sale, you would be faced with the question of when to get back in to that asset class.  Trying to guess that can be even more challenging than trying to guess when to get out.  Market timing has never been shown to work reliably.

Stop-loss orders have their place in your investment toolkit.  But as with any tool, they have both strengths and limitations.  If you are going to utilize them, use them selectively and wisely.

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