Stop Loss Orders: An Investment Tool to Avoid?

Stop loss orders are a widely used investment tool that value investors should mostly avoid. Many investment pundits frequently recommend using stop loss orders as a risk management tool. But for value investors this can be the wrong tool.

What Is a Stop Loss Order?

A stop loss order instructs a broker to buy or sell a stock once the price reaches a specified price, known as the stop price. Investors use these orders to limit losses when the price of investment decreases (if the investor is long), or when the price of an investment increases (if the investor is short).

Does a Stop Loss Order Make Sense for a Value Investor?

What investing strategies do you employ? If you are a growth or momentum investor the stop loss order totally makes sense. If you are not basing your investment decisions on valuation the idea of cutting losses is sound.

However, if you are a value investor who has done his homework, and purchased a good investment, why would you want to sell that investment just because the price decreases. A stop loss order may cause you to sell just before the stock rebounds. Studies have shown that selling stocks at bargain prices does not boost portfolio returns.

Another pitfall of stock loss orders is that you may not get your stop loss trigger price. Once a stop loss order is triggered it becomes a stop market order and will be executed at the next available price. That market price could be much different than your specified stop loss trigger price.

2010 Flash Crash

On May 6th, 2010 the stock market experienced a “flash crash” where the Dow Jones Industrial Average, already down 300 points, fell an additional 600 points in 5 minutes for a near 1000 point loss. Twenty minutes later the market had regained most of the 600 point loss. Many financial “experts” recommended using stop loss orders as a strategy to stop or limit a loss, but volatility makes the stop loss order a poor risk management strategy.

Stop Loss Order Disaster Example

Proctor & Gamble (PG), known to be a very stable low volatility stock, fell hard during the 2010 flash crash as stock loss orders were triggered and became market orders. PG went from $60 to $40 and back in less than 30 minutes.

If someone had placed a stop loss at $45, when the price of PG declined to $45, that order became a market order and the stock was sold at the next price available; possibly lower than $45. Minutes later PG had rebounded to $60, leaving investors stunned and unable to buy the stock back without a large loss.