Should Long Term Investors Use Stop-Losses?

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One of the things that I try to do in these columns is to suggest a stop-loss level when I suggest a trade. This is partly out of habit. I learned about markets in the London interbank forex market and, in my experience, those lucky enough to be paid to trade never even consider a position without being aware of where they are going to cut should the idea not pan out. I have written before about this focus on exits, but was challenged yesterday by someone who said ‘I’m a long term investor, not a trader. Stop losses are not a good idea for me’. This led me to wonder; should those investing with say a multi-year time horizon be setting stop loss levels when they buy?

The short answer is yes.

The argument against is that the long term investor shouldn’t be swayed by short term volatility. They should buy stock in a company that they believe has sound fundamentals, or anything else that they believe will provide a decent return and hold it. I understand, but see two basic flaws in the argument.

The first is fairly obvious; the assumption here is that nothing is going to change. Logic tells us that this is not the case. Calculating forward revenue, profit and cash flow for a business is not just a good idea, it is essential to a decent investor, but new technology, personnel changes and global events can rapidly alter the picture. The benefit of having stop-loss levels set in advance is that when this happens the decision will be made for you. It is a lot easier to make a rational decision once you no longer own a losing stock.

 

The above chart for BP (BP), while an extreme example, illustrates the point. Just before the Horizon tragedy, BP around $60 looked like a good investment. When disaster struck, a previously set stop-loss at, say $50 would have saved a lot of money. Without, it is quite likely that the pain would have become unbearable after a drop of around 50% and you would have sold at the bottom.

The second thing is a little less obvious, but is probably more important. Investing, like trading, involves finding a balance between risk and reward. Refusing to prepare for a loss is refusing to acknowledge the “risk” element of that balance. Many people see risk as a function of the asset mix in their portfolio, or the type of stocks they own. Stocks are more risky than bonds, small cap is more risky than large, emerging markets are more risky than domestic etc. However, lots of people with very conservative “low risk” holdings lost a lot of money in 2008-2009. Risk and volatility are not the same thing.

Controlling risk is not just about choosing the right investments. It is also about limiting any potential loss. Oh, and don’t kid yourself; even the sharpest investor picks a wrong ‘un every now and again! Those that accept this and prepare for the worst are in a much better position than those who don’t.

“Ah…” the opponents of stop-losses say “…but all of the research shows that, on average, investors who try to time the market lose money”. True, with one slight adjustment. On average, those attempting to time the market have lost money in the past. That doesn’t mean that you will. We are, after all, reminded constantly that past performance is not necessarily indicative of future performance. Your very presence here at NASDAQ.com tells me that you are not the average investor; you are more proactive and better informed.

In any case, what I am advocating is not market timing, it is merely prudent risk management. You aren’t attempting to pick tops and bottoms, simply to protect against unforeseen circumstances. If an investment lose 10-20% then it is obvious that your original case for the purchase no longer holds true. Something has changed. Rarely do markets reward loyalty, they reward those who can admit their mistakes.

The world’s major banks have their ups and downs, but over time they all make money from their trading desks. I am not suggesting that you attempt high frequency trading or become a market maker, but there are certain things that traders do that can help even the long term “buy and hold” investor. Good risk management for each individual holding by way of stop-loss orders is one.



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , Investing Ideas , Economy

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