Stop-Loss Orders Can Lose Money Quickly

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Stop Loss OrderAfter investors and their advisors experienced the precipitous market drop during the fall of 2008, many people searched for ways to protect their assets. After a year-long review of possible ideas, I decided to stay the course and not change our investment strategy. Every technique I reviewed would have put such a drag on portfolios as to erase gains over the last 10 years.

Although the S&P 500 had a flat or down decade, even my simple gone-fishing portfolio had satisfying gains over that same time period. I write every year or so about how this diversified portfolio is doing. Although they aren’t even the best funds to select today, they remain popular funds with low expense ratios.

The portfolio consists of 20% Vanguard Total Bond Index (VBMFX), 21% Vanguard 500 Index (VFINX), 10% Vanguard Small Cap Index (NAESX), 21% Vanguard Total International Stock (VGTSX), 10% Vanguard Emerging Market Index (VEIEX) and the final 18% in T. Rowe Price New Era Fund (PRNEX).

Through the end of April 2010, that portfolio has a 6.05% 10-year annual return versus 0.19% for the S&P 500 alone. Over 10 years, that’s the difference between being up 79.93% and down 1.88%. Diversification over the last decade boosted returns significantly. It doesn’t always safeguard you from market losses, but as I said, anything you do to protect yourself from losses can weigh down portfolio returns significantly.

My favorite quote last year was from former Fed chairman Paul Volcker: “You can’t hedge the world.” If you try too hard to avoid volatility, you will probably just dampen your returns and may still experience some other unexpected event (the so-called black swan), like the defaulting of municipal bonds you thought were secured.

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.

For example, take Vanguard Value ETF (VTV), which was trading at around $50 per share on May 6. Investors or advisors who wanted to protect their investment from a catastrophic drop in the markets may have wanted to sell if the markets dropped by 15%. This would mean placing a stop-loss order that would be triggered at $42.50.

Just because a market move sets off a stop-loss order doesn’t mean the investor will get the trigger price. The trigger submits the sell order as a market order, meaning it gets whatever the next market price is. Under normal conditions this might mean the stock would be sold at most for a nickel below the trigger price (i.e., $42.45).

Unfortunately, May 6 wasn’t normal conditions.

Possibly some large sale of Procter & Gamble caused a drop in the Dow. That may have triggered some automatic stop-loss orders in Dow index funds, which may then have caused other Dow stocks to drop in value.

The drop in Dow stocks could easily have triggered additional stop-loss orders. Each sell pushed stock values lower, triggering more stop-loss orders set at even lower levels. This cascade of stop-loss orders caused the May 6 free fall.

But it gets worse. The stock exchange has speed bumps in place to slow the market when it appears to be moving too fast. These curbs limited transactions from market makers at exactly the time when higher liquidity was needed. A market maker is a firm that stands ready to buy or sell a particular stock on a regular and continuous basis at a publicly quoted price. Market makers move that price gradually, which keeps the market orderly.

Without market makers, when there are more sellers than buyers, a stock has no price. Some of these market orders got picked up by exchanges linked to the New York Stock Exchange. Others got picked up by stub orders for a penny a share.

Between 2:40 pm and 3:00 pm, at some points no one knew what certain stocks or ETFs were worth. Consequently, the value of many ETFs hit virtual zero. Stop-loss orders for VTV set at $42.50 got executed for $0.10 a share. Then after every stop-loss order was finally triggered, the plunge came to a halt.

After the last of the stop-loss orders was cleared for pennies a share, the automatic selling stopped. At that point many institutional investors or their automated systems stepped in to bargain hunt and pick up shares for fractions of what they were worth. The market quickly rebounded, recovering most of its value in the next 20 minutes.

You can see this effect on Google finance, where it looks like the stock price for VTV bounces off zero that day at 2:52 pm. These trades were not an isolated event. Many stocks sold for just a penny per share. These trades show a market in free fall with a snowball of cascading stop orders and no market makers stepping in to set a reasonable price.

The statistics are already being cleaned up to erase this trading anomaly. Some sites still show the year low of these ETFs as $0.10 or even $0.00. But other sites now have the edited low of VTV as $18.58 or $19.32 that day.

After the close of trading on May 6 and numerous investor and advisor inquiries, the NASDAQ mandated canceling these clearly erroneous trades. But they insisted these were legitimate market orders executed in a reasonable manner and were not aberrations or mistakes in the system. In other words, you have been warned that the events of May 6 were a natural consequence of using stop-loss orders during a market free fall.

Thus the stop-loss order technique failed at the very moment it was supposed to save the average investor. It tried to sell in a free-falling market and only succeeded in dumping valuable stocks on a dime and for a dime. Even after adjustment, some investors lost 63% on a day where the stock market only closed down 3.62%. I doubt investors or financial advisors will be advocating the widespread use of stop-loss orders again in the near future.

But if they do, I suggest putting in a series of limit orders to buy stocks or ETFs at half their current value. If investors ever want to dump their shares for half their value, I’m more than willing to buy at that price.

Be a contrarian. Buy when people are selling. Especially when they have automated their panic with stop-loss orders.

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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…)