How Losing Less Can Cost You More
A stop-loss order offers downside protection, but at a price that may be higher than you think
(MONEY Magazine) – In a choppy stock market like today's, brokers tout the value of stop-loss orders. A stop-loss automatically sells a stock if it drops below a predetermined price. If you buy at $20 a share and can't bear to lose more than 20%, you can set a stop-loss at $16. Then, the story goes, you can hit the beach knowing that you've protected your downside. Your broker may even tell you a stop-loss is "free insurance."
Unfortunately, like so many Wall Street tales, this one is part fable. A stop-loss can certainly give you peace of mind. But it can also cost you dearly.
Why It's Hard to Let Go
Let's start with the good side of the story. Each year you can use your investment losses to offset your capital gains and lower your taxable income. But first you have to admit that you were dumb enough to buy a loser, something many of us have trouble doing. A stop-loss solves the problem. "It's kind of like telling the bartender, 'Stop me after I've had three drinks,'" says finance professor Meir Statman of Santa Clara University. "You do that while your head is clear, not after you've had a couple and your resolve is weakening."
But there's a flip side. The great investing analyst Benjamin Graham taught that a stock has a price but a company has value. He explained that the intelligent investor should compare the price of the stock against the value of the business. If the value per share is higher than the price, that's what Graham called a margin of safety. So long as you've studied the business enough to be confident about its value, a fall in the stock price is good news: You can buy more shares below their true worth.
When Insurance Isn't Free
Any stock can take a short-term pounding, even if its long-term future is bright. I asked analyst Kevin Johnson of Aronson Johnson Ortiz, a money-management firm in Philadelphia, to estimate the odds of getting stopped out over various holding periods. Based on daily trading in 3,164 major U.S. stocks in 2004, Johnson found that if you set a 10% limit on your losses, you had a 7% chance of being stopped out during any two-week period. Even with a 20% stop-loss, you had a one-in-10 chance of having to sell out within three months. All too often, you would get forced out by short-term blips. That protects your broker, not you. If you sell 100 shares at $20, a brokerage commission of $19.95 eats up 1% of your capital. So much for free insurance.
It is true, of course, that a stop-loss would have gotten you out of Enron or WorldCom before they went to zero. But there's no guarantee that you'll get the price you specify. Say you buy a stock at $40 and set a stop-loss at $36. If bad news breaks, the stock could go from $36.25 to $31.79 in a single trade. When trading is this wild, your broker can only stop you out at $31.79 or less. What's more, Enron and WorldCom are the exception: In the long run, most stocks go up. So while a tight stop-loss might limit the remorse that comes from holding a loser too long, it also exposes you to the regret of watching a stock you just sold go right back up.
You can find peace of mind without incurring high turnover and brokerage bills. Set any stop orders at least 25% below your purchase price. And train yourself to take losses--and reap the tax benefit--without using stop orders. Robin Hogarth, an expert on financial psychology at Pompeu Fabra University in Barcelona, suggests changing your log-on password to something like "dumpmylosers." After typing that a couple of times a day for a few weeks, you should internalize the idea and become less resistant to it. There's also peace of mind in beating Uncle Sam.