The subject of whether to use a stop loss is a controversial one for many investors.
It’s a relatively simple technique, whereby an investor decides to sell a share if it falls a certain level below the price at which they bought (typically around 10% below). Some people use a trailing stop loss, where their sell price is adjusted upwards if the current price rises.
The main advantage of using stop losses is that they bring discipline to your investing. There’s no emotion involved, so you avoid the situation of falling into denial that you’ve made a bad call.
If you’re an investor who tends to hang on to your investments whatever happens, then you might find stop losses save you much in the way of portfolio pain. In our view though, if you have this sort of mindset, you probably shouldn’t be investing in shares in the first place!
Stop losses do have many disadvantages though. For starters, you end up buying and selling more frequently. All else being equal, this will simply depress your overall returns, because you’re leaking more in the way of commission and the spread between the buying and selling prices.
Stop losses can save you from racking up big losses on individual shares of course, should the price fall continue. There’s no certainty it will though. The fall could be a temporary one and the price could subsequently rebound.
Over many trades and many years, how these two factors even out is hard to predict. But if you’re a relatively competent share picker, selecting shares in solid businesses that are cheaply valued, large fallers are likely to be quite rare and outweighed by occasions when the price rebounds.
Using stop losses means you have to keep a close eye on your portfolio too, which may not always be possible. Paying excessive attention to the current price will often result in overtrading as well.
Although some brokers will allow you to set automatic stop losses, there are many tales of people getting thrown out of positions because of large, but very short-term, price moves, especially in the first hour of trading when prices tend to be very volatile.
We generally don’t like using stop losses. If the price of a share does fall, it’s preferable to re-examine the reasons for buying, with as much emotional detachment as possible of course.
That’s never an easy thing to do. In the absence of any change in the company’s fortunes, it might make more sense to add to a position at a cheaper price than sell out.
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