Downside Protection That Doesn’t Protect

After reading my article last week (that can be found here) that discussed how we use limit orders to protect us from wild price fluctuations (among other reasons), one of my favorite readers wanted to know why we don’t use stop-loss orders.

A stop-loss order is different from a market order, which says ‘do my trade at any price’ and a limit order, which says ‘do my order at a specific price or better.’

A stop-loss order says ‘if the price falls below some threshold, enter a market order.’  There are also stop-limit orders that says, ‘if the price falls below some threshold, enter a limit order at a specific price.’

The stop-loss order sounds appealing because, as described, they sound like they protect you from losses.  I’ve heard people say that they have stop-loss orders that are set to trigger if a stock falls five percent.

The problem with these types of orders is that it removes human judgement from the equation in times of extreme stress, which in our view is often when you need the judgement.

Last week, for example, there were plenty of stocks that opened lower by 10 percent and people that had stop-loss orders were executed at the minus 10 percent level because the order was set to take the market price.  If those investors thought that their losses were limited to five percent, they were sadly mistaken.

Stop limit orders are a little better in that you aren’t immediately executed when the stock price falls below your stop price, but then you didn’t get out as intended and you may still have other problems if the market suddenly turns up sharply as it did last week.

Legendary investor Peter Lynch has a number of great quotes on stop loss orders and while I couldn’t find the one that I wanted, it said, in effect, show me a portfolio with 10 percent stop loss orders and I’ll show you a portfolio that loses 10 percent.

I did find another one that was as good, “If you can’t convince yourself ‘when I’m down 25 percent, I’m a buyer’ and banish forever the fatal thought ‘when I’m down 2 percent, I’m a seller,’ then you’ll never make a decent profit in stocks.”

This morning, I read someone describe a different kind of stop order that I thought was funny and true: if the market falling by a certain percentage bothers you, stop watching the financial channels, stop checking quotes on your phone and limit yourself to looking at your account to once a week.

It reminds me of a quote from Vanguard founder Jack Bogle, who has said repeatedly over the years, ‘don’t just do something – stand there!’

Of course, we’re not just sitting around – we’re looking at client portfolios and, when appropriate, are engaged in rebalancing the portfolio or tax-loss harvesting.

But if Peter Lynch and Jack Bogle quotes don’t do it for you, consider what The Bard had to say in The Scottish Play, ‘it is a tale, told by an idiot, full of sound and fury, signifying nothing.’

Obviously, short-term market performance is full of sound and fury signifying nothing, but don’t think of me as the idiot telling the tale!