Mailbag: Stop Before Using Stop Orders

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Mailbag: Stop Before Using Stop Orders

I’ve heard that I should have stop loss orders for every stock or exchange traded fund position I have. That way, if I set the stop loss order for 10% I can never lose more than 10% if the market crashes. Is that a good idea?

We do not recommend using stop loss orders.

In a recent Investment Advisor magazine article by Noah Hamman, “Stop Before Using Stop Orders“, he writes:

On the surface, stop-loss and stop-limit orders seem like great ideas. All one needs to do is simply place the protective order, and if the market ever falls to the price indicated on the stop-loss or stop-limit, the order is executed and that will be that.

That theory conflicts with the reality of how these orders play out, though, and ignores temporary market “failures” like the ones that occurred on Aug. 24 or the flash crash on May 6, 2010.

Forgetting market mechanics and function for just a moment, both crashes came and went in a matter of minutes — each literally less than one hour. Markets whooshed down, countless stop orders were executed, and then markets whooshed right back up, arguably resulting in at least a semi-permanent impairment of capital.

While stop-loss orders were intended to offer a measure of protection, they in fact made it worse on both occasions. The automated nature of these orders cannot recognize these types of events for what they are, and these events do not represent fundamental reasons to sell. For example, a stock that closed two consecutive days at $60, but spent an hour in between trading below $50 due to some perceived malfunction in the market, should not be sold.

We’ve written about some of the reasons not to use stop loss orders in our article, “Stop-Loss Orders Can Lose Money Quickly” in which we wrote:

One strategy we rejected as a hedge against a precipitous market drop is a technique called a stop-loss order. After purchasing a stock or exchange-traded fund (ETF), an investor can place an additional order with instructions on when to stop holding the security and sell it. Stop orders are triggered when the security reaches a specific price.

Sell limit orders are placed above the current market and execute when the security reaches that price. Sell stop orders are placed below the current market with the objective of limiting losses if the market value drops.

We recommend avoiding these types of orders for downside protection. Getting out of the markets at a 15% loss doesn’t help you know when to get back in. Most investors who get out remain there until the markets rise well above the triggering values. Getting out is also the exact opposite of rebalancing. When the market drops, rebalancing your portfolio would mean selling bonds and investing more in the markets, not getting out of the market.

We think these are good reasons to avoid stop-loss orders, but many others disagreed. Thousands of investment advisors recommended this technique to their clients. Now it looks like this advice may have been the cause of the market plummet.

There are many reasons to avoid stop loss orders, but the main one is that they make you do the exact opposite of smart rebalancing by  selling stocks at their low point.

Now, it appears that the New York Stock Exchange agrees. They have announced that they are eliminating stop orders in February 2016. Hopefully, this will encourage people to invest more wisely.

Photo used under Flickr Creative Commons.

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David John Marotta is the Founder and President of Marotta Wealth Management. He played for the State Department chess team at age 11, graduated from Stanford, taught Computer and Information Science, and still loves math and strategy games. Favorite number: e (2.7182818…)