Stop-Loss Orders Don’t Stop Losses

STOP_sign

I always find it amusing when individuals tell me about stocks they buy and then tell me they put a stop-loss order on their stocks so that they don’t lose too much money. Shouldn’t individuals be thinking positive about their investments rather than worrying about how much money they might lose? With the recent drops in the stock market, individual investors are more likely to overreact and sell their stocks for losses rather than keeping with their original goal of building a well diversified, balanced portfolio for the long term. To some people the stop-loss order is essentially “protecting” their capital in the event the market continues to drop. It might give people some comfort, but the stop-loss order actually does nothing to really protect your capital from large losses.

A stop-loss order is an order put against an equity that executes in the event that the price of drops to or below a specified dollar amount. An example of executing a stop-loss order would be to buy a stock at $25, and then putting a stop-loss order to sell the stock if it reaches or goes below $23. In this example, as long the stock stays above $23 the individual will continue to hold onto the stock. If the price of the stock never reaches $23 or below, then the stock will never sell. However, once the price drops below $23 then the order executes and the stock is sold. On the surface, it would seem like the individual would only lose at most $2 on the stock, but in reality it doesn’t work this way.

One of the faults of a stop-loss order is that it doesn’t sell the equity at the price that is set. Rather it sells once it goes below that price. This can result in catastrophic losses when an equity gaps lower by a larger dollar amount. In the above example if the equity were to open the day down $5, the stop-loss order would execute and sell at a price of $20, not $23. This represents a loss of $5 per stock rather than $2 which is what the individual might have wanted. When markets really start to decline, you can see how stop-loss orders can snowball that effect into mass selling. There are many ways to protect oneself from a declining market. Using the stop-loss order just isn’t one of the effective methods.

Doing It The Right Way

As I mentioned, there are many strategies that large investment firms and advanced investors do to weather the downturns of a sour market. As a novice investors, those are strategies that we shouldn’t be getting ourselves into. There is too much complication, too many transactions to deal with, and will ultimately lead to a lot of confusion. Confusion is definitely something we don’t want to create when we’re trying to build a simple investment portfolio.

The easiest way to mitigate losses is through a well-balanced, diversified portfolio. I’ve mentioned this many times in many posts that the best investment portfolio is one that is diversified and balanced on a regular basis. So just how well does a balanced portfolio measure up during volatile times like the one we are currently experiencing? Let’s take a look.

Over the last month the S&P TSX and S&P 500 have been doing this:

SP_TSX_DOW_1_month

Those are pretty big drops of 7% and 6% respectively.  Had one been holding a portfolio consisting of stocks only, that individual would bear the brunt of that fall.  The question that everyone should have is what happens when we have a diversified portfolio that holds more than just stocks. Let’s take a look at the Global Couch Potato formula consisting of 60% equities split amongst three regions and 40% in bonds.

20% Canadian Equities (VCN) down 7%
20% US Equities (VUN) down 4%
20% International Equities (XEF) down 5%
40% Canadian Bonds (VAB) up 1.5%

Cumulatively, this portfolio would be down 2.6%. It’s a far cry from a full 6-7% drop that the S&P TSX or S&P 500 suffered. One of the key points to note here is that bonds and stocks have a negative correlation to each other. In general, bonds are seen as a safe haven when the stock market is volatile and tend to outperform when stocks fall. Having investments that have negative correlation to each other is a strategy that can be used to mitigate risk.

So what happens if other types of investments are brought into an investment portfolio. Let’s take this even further and add more different asset types with the Complete Couch Potato portfolio.

20% Canadian Equities (VCN) down 7%
15% US Equities (VUN) down 4%
15% International Equities (XEF) down 5%
10% Real Estate (XRE) down 1.5%
10% Real Return Bonds (XRB) up 2.5%
30% Canadian Bonds (VAB) up 1.5%

A portfolio that is more diversified such as this would be down 2.2% over the last month. It’s true that you read this and might say that you are still losing money with a diversified portfolio, but the point is that your losses are diluted. The fluctuations are less virulent and the downturns are easier to stomach. With more asset types in an investment portfolio, the less impact any significant drop in one asset class will have on the entire portfolio. This is the precise reason why diversification is necessary.

Stay Positive

Remember that the goal of investing should be long term. Don’t worry about the short term fluctuations. The past month will seem like a small road bump in the long run. It’s important to not overreact with our emotions when it comes to investing in the long run. The goal is to look forward and be positive about the economy, be positive about your finances and be positive that the human race is here to evolve and improve. With improvement and innovation comes greater opportunities for corporations and companies to grow their profits which will ultimately be shared back you.

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