Save me, stop-loss!

There is no end to the stock crash, but I am quite relaxed because my stop-loss has saved me. This is more or less the wishful thinking for those who use it. What is it anyway?

In a stop-loss order, a security is bought or sold when a certain price is touched. For example, someone holds a stock and places a stop-loss at 15 percent below their acquisition price. The idea is to protect against larger losses. If the stock actually falls by 15 percent, it is sold as a market order. The reverse would also be possible: buy a stock when it reaches a higher price - but this is rather unusual among private investors.

Things often turn out differently than you think

Stop-loss orders were particularly popular after the 2008 financial crisis. At that time, prices fell longer and deeper than investors thought they would. Relieved to have sold with a stop-loss at a minus of 20 percent, they watched the price halve. Then they bravely bought again. Yeah, right!

Unfortunately, this is only an idealized assumption that almost never happens. For every sale that is followed by a further drop in price, there are countless variants in which the stock rises again immediately after the sale, or goes down only a little further, or does something else unexpected. There are no limits to the randomness of price movements.

Growing decision trees

There may be trading strategies where the use of stop-loss orders makes sense as seen for example, in computerized models that trade according to signals. Even there, it is not a panacea. The use of this form of order usually leads to lower volatility, lower drawdowns but also lower returns. The ratio of return to risk rarely improves.

Investors who use stop-loss based on gut feeling overlook many important questions. Where do I set the stop-loss? At an arbitrary price that looks “right” on the chart? At a fixed percentage from the buy price? At a multiple of the daily price fluctuation? Depending on the traded volatility of the last 20 or 60 days? The list of possibilities could be continued indefinitely.

In addition, another question remains unanswered: What to do after the stock has been sold due to the activation of the stop-loss? Buy it again? If so, when and at what price? If not, what to buy instead? Simply buy another stock and then put a stop-loss on it again? A complex world full of decision trees opens up. Who needs that?

From falling prices and disappointed investors

For fundamental investors, like myself, stop-loss orders are out of the question altogether. They completely contradict the philosophy of buying excellent business models and holding them for a long time. Ideally, I strike when a sell-off is called. Because the company may have delivered a bad quarter or because the overall market is going through a general correction. The cheaper the better. If the price falls, I want to buy and not sell because of a stop-loss order.

Unfortunately, as a fundamental investor, you rarely catch the absolute low price. Rare is a euphemism. Never would be statistically more correct. Many investors are disappointed when a stock they have just bought continues to fall.

I, on the other hand, already reckon that the market is always like this anyway and buy in stages. This allows me the opportunity to buy more cheaply. Even this strategy is not a cure-all. Sometimes you buy a first position and the price immediately runs away upwards. Then you are in the market with a much too small position. This also fits my temperament in that manner.

Let us talk about it

You see, regret is around every corner. There is simply no such thing as perfection in unpredictable markets. It is much more important to come up with a strategy that suits you and that you can stick with over the long term. Do you already have one?

My team of independent active investment consultants and I will be happy to assist you. For example, if you want to philosophize about the pros and cons of stop-loss orders, just get in touch with me.

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