Another overlooked facet in the decision to take a big gain, small gain or small loss is the reality that the capital may be redeployed in a less risky, more productive asset. Let us assume the investor wants to reduce cyclical sector risk in his/her portfolio, and rotates the $36,000 ($34,000 + $2,000 gain) into the lower beta volatility world of utilities. The erroneous assumption by those who do not value stop-limit loss orders or long-term trendlines is that the “sell” event results in missed opportunity. On the contrary, rotating into XLU provided greater opportunity with less portfolio volatility.
Equally worthy of note, suppose the investor simply wanted to lower stock risk by redeploying the capital into intermediate-term treasury bonds. He/she would have profited with an asset allocation shift into iShares 7-10 Year Treasury (IEF).
Are stop-limit loss orders perfect? Far from it. Is the 200-day moving average sacrosanct? Maybe to the technical analyst, but otherwise, it has plenty of flaws as well. The reason a long-time money manager like myself uses these tools is because I recognize the emotional intelligence of maintaining one’s discipline and the mathematical sensibility of insuring against catastrophe. Applying insurance principles to the investing process – no matter how one chooses to do it (e.g., stops, trendlines, put options, hedges, etc.) – is more critical to one’s financial well-being than finding the next “biotech biggie.”
I will add here that I believe so strongly in the necessity of insurance, I partnered with FTSE-Russell to create the FTSE Custom Multi-Stock Hedge Index. Some are calling it the “MASH” Index. Indeed, if a bearish downturn were to occur, the components of this index would likely bolster one’s portfolio’s health. The index is comprised of assets that have a history of advancing when stocks struggle – U.S. bonds, foreign sovereign debt, currencies, gold – yet the index has the potential to perform irrespective of how well stocks perform. You can learn more about multi-asset stock hedging here.