What is your opinion of stop-loss orders?
It sounds so seductive: Who wouldn't want to stop their losses?
Say you go on vacation over the holidays or you don't have time to monitor your portfolio. You can sleep well at night knowing that your stop-loss orders will protect you from losing buckets of cash if one of your stocks plunges.
That's the supposed benefit of stop-loss orders. But if you're a buy-and-hold dividend investor like me, stop-loss orders can actually do more harm than good. Here's why.
Locking in losses
When you enter a stop-loss order, you're instructing your broker to sell your shares if and when they fall to a certain price.
While that may be fine for an investor who buys and sells frequently according to some sort of short-term trading system, for a long-term investor it's accomplishing the opposite of what your goal should be.
Think about it. You're telling your broker to lock in your losses if the stock falls to a certain price.
Assuming you still like the company, shouldn't you be more interested in buying shares when they're down instead of selling them?
Missing the rebound
If I'd had stop-loss orders on my stocks during the financial crisis of 2008-09, I'd be kicking myself right now. Why? Because I probably would have sold most or all of my holdings, and quite possibly missed the powerful rebound that followed because I would have lacked the courage to get back in.
In exceptionally volatile markets, stop-loss orders can be even more problematic.
With a straight stop-loss order, when the stock reaches a predetermined price, the order automatically converts to a market order.
That means your broker will sell the shares at the best available price – which isn't necessarily the price at which you placed the stop.
The sale price could be lower – potentially a lot lower – if the stock "gaps down" on negative news or if the entire market experiences a temporary panic such as the 2010 "flash crash" that erased nearly 1,000 points from the Dow Jones Industrial Average in about 20 minutes.
Do you really want to sell your stocks in a chaotic environment like that? I don't.
The only reason I would sell a stock is if its outlook changed fundamentally for the worse – not because its price suddenly dropped.
Limiting the stop-losses
After some investors got burned by stop losses, some brokers now insist that if clients are going to use them, they must also include a "limit" specifying the minimum price they will accept on a sale.
If the trade can't be executed at or above the limit price, the sale will not go through.
"In a volatile market, a stop-loss limit order may not be executed, in which case the investor will continue to be exposed to a declining stock price," the Investment Industry Regulatory Organization of Canada (IIROC) said in a 2011 bulletin.
The big problem with stop-loss orders is that they transfer control from the investor to a computer. As a long-term dividend investor, I only invest in profitable companies with a track record of rising earnings and dividends – utilities, pipelines, telecoms, power producers, blue-chip consumer stocks and banks, for example.
When their prices fall, I don't treat it as an emergency or an excuse to bail. If the business remains sound – maybe the market is just having a bad day or the company reported a bad quarter – I hang on or consider buying more.
By choosing conservative companies, I stay away from speculative stocks whose fortunes could change dramatically and without notice. That's another reason I don't use stop-loss orders.