Sabela Capital Markets was quoted in this U.S. News and World Report article about using stop-loss orders to avoid deeper losses during a market plunge, “Protect Your Portfolio With a Stop-Loss Order”.
Here’s my take about stop-loss orders. A stop-loss order is a trading tool. And investing is not trading. Resorting to tricks to try and cut losses does not add value to your odds of investment success in the long term. I wrote a short blog on why investors shouldn’t trade here, Should You Day Trade?.
If you are too anxious about a market drop, it’s more important to figure out whether your portfolio asset allocation continues to conform to your tolerance for risk. Your tolerance is based on your emotional response to risk. This is different than your capacity for risk, which is your ability to take on risk based on your financial situation. You can have a high capacity for risk and low tolerance for risk. As long as it doesn’t exceed your capacity for risk, your tolerance for risk should be the threshold for your asset allocation because it will directly influence how disciplined you remain to your investment plan during market turbulence. And discipline is one of the main determinants for long term investment success. If you are taking on too much risk, you’ll be more anxious and likely to veer off. If you are comfortable with the amount or risk that you are taking, then you’ll be more likely to stay in your seat.
When you are anxious about a potential market plunge, a stop-loss trigger is the wrong solution. In fact it just perpetuates bad investing actions that can be detrimental to returns.
First, there is no clear way to rationally define what that stop-loss price should be. Should it be based on technicals, fundamentals, percent drop in asset value, or by something else? Then, after it’s triggered, when do you get back in the market? This second question is even more important because reacting to market dips and swings hurts performance. It can determine how much of the market return you capture during a rebound. And most of the market returns come from just a few positive days each year. For example, from 1970-2015, missing the best 25 days would have reduced your S&P500 return from 10.27% to 6.87% (source). That’s a big impact on your returns. And unfortunately, no one has the skill to time the market, least of all the professionals. To do that you need a crystal ball, to be able to predict tomorrow’s news. Instead, discipline can help your odds of success.
To remain disciplined, you have to be comfortable with the level of risk that you are taking, which goes back to my initial point. If you are worried about market drops to the point of thinking about stop-loss triggers, then think about reducing your portfolio risk exposure instead. By accepting the expected returns and risks of your portfolio, you’ll be more relaxed and rational about investing. And you’ll be more likely to stick to your investment plan for the long term. It really is the best way to improve your odds of success.