When stop-loss orders may not be an investor’s best friend
Stop-loss orders can be too safe for an investor’s own good, says this U.S. advisory, which doesn’t set target prices for stocks either.
A stop-loss order on a stock seems like a very useful thing.
So is a safety net under the flying trapeze. But a stop-loss order may not be quite as effective as that time-honoured safety device. At times, it can do more harm than good.
That’s why one leading U.S. advisory doesn’t use stop-loss orders as part of its selling strategy.
By the same token, Dow Theory Forecasts doesn’t set target prices for the stocks it recommends either.
You could almost say it doesn’t use a belt or suspenders. More to the point, this venerable newsletter would argue, it does not indulge in short-term thinking.
The advisory illustrates its philosophy with a specific case — a stock that would have broken the heart of any investor who sold too soon.
May not boost returns
Many subscribers have asked this advisory: “Why don’t you use stop orders to limit your losses when stocks go down?”
The answer might surprise many investors: “Because selling losers may not boost portfolio returns.”
If you buy a stock at $50, and don’t want to risk a drop of more than 10 per cent, you can place a stop-loss order that kicks in and sells the stock if it drops to $45, 10 per cent below the purchase price.
“Admittedly the idea of controlling losers sounds good,” agrees the advisory. “And in cases where a stock’s share price action is a central reason you own it, a stop order can make sense.”
But there are two ways in which it can go astray.
Out near the bottom
First and most obvious, stocks often bounce back, the advisory reminds us. Let’s say you own a portfolio of high quality stocks, and the market goes down. It could fall 10 per cent and many of your stocks could be sold at the stop price, or “stopped out.”
Most stocks tend to move with the pack in the short term, no matter how sound they may be. “All too often, stop-loss orders get you out near the bottom, and you miss the subsequent rally.”
Second, it’s actually possible to miss your stop-loss price and lose more than you bargained for.
“Suppose your $50 stock declares disastrous earnings after close and opens at $38 the next day,” the advisory says. “Your order would be executed at or near the open, most likely well below the $45 you had hoped to get. You could use a limit order that sells only at $45, but in this case a stop-limit order would result in no sale.”
And over the past two years, even a number of solid stocks have had one unhappy quarter that turned the market against them.
The advisory demonstrates with the 14 stocks added to its Buy List in 2009. If you had set a stop-loss order of 10 per cent below the price at which the stock was added, you’d have sold 12 of them at roughly a 10 per cent loss.
Yet 10 of these stocks now trade above the price at which they were first recommended. If the goal of a stop-loss order is to limit losses by selling losers before they dip even lower, it would have worked with one of the 14 stocks, the advisory reports.
Otherwise, you would have sold yourself out of some handsome gains.
A moving target
And why doesn’t the advisory use target prices, others ask. Then investors would know when to take profits on a successful stock.
The answer is simple, replies Dow Theory Forecasts — “the target is always moving.”
When this advisory recommends a stock, “we aren’t implying a certain return, but rather that the stock will outperform the market over the next 12 months.” Target prices just get in the way.
Let’s say you set a target 30 per cent above the purchase price. Sounds good, but what if the broader market rises 30 per cent and the stock moves with it — and still has good reasons for going higher? That is, it still has all the promise that made you buy it in the first place.
“Do you sell a stock with potential to outperform just because it has hit a prearranged price?” asks the advisory. “Not if you trust the reasons you recommended the stock in the first place.”
Consider one sterling example. Cognizant Technology Solutions (NASDQ-CTSH) is an information technology consulting and outsourcing specialist. When it was added to the Buy List in December 2008, says the advisory, “we saw an attractive valuation and potential for profits higher than market expectations.”
The shares could have been sold at a 30 per cent profit in April, but the reasons that made it a good buy in the first place still seemed valid.
“The shares are now up 157% from the purchase price and we still haven’t set a target price,” concludes the advisory. “Our strategy with Cognizant has not changed despite the big gain — we will sell when we no longer believe the stock represents a top pick for 12-month returns.”
The stock’s chart looks like a jet taking off and it now trades at $46.
In effect, says this advisory, if you have confidence in a stock, there’s no need to hem yourself in with arbitrary restrictions.
A safety net is all well and good, unless it saves you from even bigger profits than you expected.
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