For a retail investor, or even professionals, investing in ASX shares can be nerve-wracking.
Experts tell us to look long-term and not check your portfolio value everyday.
But your stomach can't help but churn when you see Alan Kohler on ABC News mention that one of your shares has dropped 20% that day.
To help you sleep at night, some investment gurus recommend using stop-loss orders.
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What are stop-loss orders?
The stop-loss mechanism is described in detail in The Motley Fool's investor glossary.
But a short way of describing it is it's an order to sell that becomes immediately active when a stock hits a certain price.
That threshold for action is called the 'trigger price'.
"For example, suppose you bought Afterpay Ltd (ASX: APT) at $80 a share and you want to limit your potential losses to 20%. You would then set a stop-loss order for $64," states the glossary.
"If the Afterpay share price falls below $64, your shares will be sold. This limits your loss to 20% of your initial capital."
A stop-loss order, despite its name, can be used to both limit losses or lock in profits.
If you set the trigger to be higher than the purchase price, then the shares will sell after it reaches a certain amount of profit.
But here's why you shouldn't use stop-loss orders
This all sounds terrific, you say.
But the trouble with stop-loss orders is that it is a transaction made purely on a numerical basis. The decision to sell has nothing to do with how the company is performing or what its prospects are like.
Author of the Market Matters newsletter, James Gerrish, pointed out that an ASX share can easily suffer a temporary paper loss of 10%, 20% or worse on any given day.
"At Market Matters, we exit a position when the reason that we hold the stock has gone, especially from a risk/reward perspective, and/or the stock no longer represents the value it once did," he told subscribers.
"That's not about being a 'value' investor, but an investor targeting value in many forms."
While stop losses have their place in purely mechanical, short-term trading strategies, they don't make sense for long-term investors.
"Put simply, I believe stops at say 5% or 10% have no logic as it's purely a predetermined monetary decision as opposed to taking into account the situation today," Gerrish said.
"Markets are like a constantly evolving amoeba and should be evaluated as such."
Gerrish admitted stop-losses can be used if it helps an investor sleep at night.
But even it isn't fool-proof.
"With regard to pre-set stops, there are no guarantees of [sale] price," he said.
"A stock may be trading at $10 and you have a stop at $9 — but, after some bad news, the next trade is at $8, you will be filled around $8 not your stop at $9."
