Are Stop-Loss Orders a Good Idea?

Stocks Article

Charles Schwab & Co., Inc.

Call us at 866-232-9890

Send us an email

Printer-friendly
Type Size: A A A
Email to a friend

Are Stop-Loss Orders a Good Idea?
by Greg Forsythe, CFA, Senior Vice President, Schwab Equity Ratings®, Schwab Center for Financial Research
Updated September 8, 2008

Many investors find stop-loss orders (also called sell-stops) intuitively appealing. If you can limit your loss in any given stock to, say, 10%, then other stock holdings that provide large gains will more than make up for stocks where you take modest losses.

That sounds great in theory. Yet, while the size of a single position's loss may be limited, they do nothing to prevent a string of successive "limited" losses.

Investors can potentially do better in terms of maximizing long-term average portfolio returns by trading on signals (such as those embodied by the Schwab Equity Rating grades), not price volatility-induced noise.

There are no free lunches in investing, and stop-loss orders are no exception.

Stock market liquidity and stop-loss strategies
Short-term stock price changes come very close to being normally distributed. In other words, if we plotted the one-month price change for all U.S. stocks, the resulting graph would appear as a familiar bell-shaped curve. The price changes of most stocks would be in the range of plus or minus 10% compared to the overall market, but a small number of stocks would have larger price changes—some positive, and an approximately similar number negative. Clearly, you'd like to eliminate the possibility of experiencing the large-loss portion of the price change distribution. But practically speaking, can this be done?

Let's say you implemented a stop-loss strategy by entering a limit order to sell any stock in your portfolio if its price falls 10% below what you paid for it. Will this limit your loss on any one stock to 10%? Not necessarily, for several reasons.

First and foremost, stock prices are always changing. For example, if you entered a $9 sell-stop order for a stock you purchased for $10, the first quote at $9 or below would trigger your limit order and convert it to a market order. The very next trade in the stock is yours at whatever price the market offers. There's no price guarantee, meaning your order may be executed at a price lower than the $9 trigger price. Because of bid-ask spreads in the stock market, your sell order is likely to be filled at the bid—often below the last transaction price.

Worse yet, in cases where you'd benefit most from a stop-loss strategy, the market often doesn't provide the liquidity you need. If, for example, a negative news story triggers a price plunge in a stock you paid $10 for, it's possible the first trade below your $9 sell-stop could be well below that price, resulting in a loss on that position much larger than 10%. Finally, in all cases, when your sell order is executed you'll pay a commission, adding to your overall loss.

In my experience, these marketplace realities conspire to produce a loss that exceeds any stop-loss target by 1%-3%. And remember, we haven't even included the spread and transaction costs of purchasing a new stock to replace the one you just sold!

The implicit forecast built into any stop-loss strategy
Next, let's consider the rationale behind any stop-loss strategy. For an investor who only holds stocks, the implicit assumption is that for any stock that triggers a sell-stop, it's better to sell and reinvest in another stock than to hold on to the original position. In other words, your actions imply that you expect the stock you sell to subsequently underperform the new stock you bought—or more generally, to underperform the market. How reasonable is this belief?

Think back to the bell-shaped curve of short-term price changes. That distribution implies that in the absence of new information on a given stock, stock price changes are random and equally likely to be positive or negative. If a random price downturn triggers a stop order, the new stock you purchase is just as likely to go down—and perhaps trigger another sell-stop—as it is to go up. And the stock you just sold is just as likely to rebound as it is to continue dropping. The result? Your sell-stop strategy accomplishes nothing other than driving up portfolio turnover and related costs.

You might argue that stock price changes aren't random: A stock price that triggers a sell-stop is probably dropping in reaction to bad news or changing sentiment. Indeed, information drives most large, short-term price changes. But does that validate the use of sell-stops?

If the stock market is efficient in processing the flow of new negative information, then the price of an existing holding will immediately drop to its new fair value, and the damage is done to your portfolio. The next price change for that stock (or for a new stock you replace it with) is once again random—equally likely to be up or down.

You might further argue that the stock market isn't perfectly efficient and prices don't immediately adjust to fair value, leading to situations where sell-stops might be beneficial. For example, say a company announces a negative earnings surprise early in the trading day. The stock drops 8% right after the announcement, but continues to drift downward throughout the day as investors absorb the information, and closes down 15%. In this scenario, a 10% sell-stop order would have limited an investor's losses, at least for that day.

So ultimately the question is what happens to stock prices after large, short-term price drops? Do prices continue to fall, or are they just as likely to rise?

We looked at the behavior of stock prices from March 1986 through March 2004, and analyzed prices for the largest 3,200 stocks at each month-end using data provided by Compustat. Interestingly, many stocks that dropped at least 10%, 20% or 30% relative to the market (as measured by the S&P® 500) over the previous one or three months, rebounded to outperform the market on average over the month following their initial large price drops. However, as we zoomed out to look at the first three to 12 months, we found these stocks tended to underperform the market by 1% to 4%.

This suggests sell-stop strategies might be slightly helpful in avoiding longer-term losses. But don't forget, increased transaction costs may well erase any potential savings.

A better way to limit losses
Fortunately for Schwab clients, there may be a more effective way to decide what to do when you're faced with a big loss in an existing holding. As in the previous study, we isolated stocks with large price drops, but this time we grouped the stocks based on their Schwab Equity Ratings® after the price drops occurred.

We found that stocks rated A or B, after their price drops, rebounded to significantly outperform the S&P 500 index on average over the subsequent one, three, six and 12 months. By contrast, stocks rated D or F after their price drops significantly underperformed the market on average over the subsequent periods.

While I must emphasize that these are back-tested results, and no guarantee of future performance, our findings suggest it's better to decide whether to hold or sell a stock based on its current fundamentals and current outlook, not its past price movements.

Important Disclosures

The Schwab Equity Ratings® are not personal recommendations for any particular investor. They do not take into account the financial, investment or other objectives and may not be suitable for any particular investor. Before buying, investors should consider whether the investment is suitable for themselves and their portfolio. Additionally, investors should consider any recent market or company news. Stocks can be volatile and entail risk. Individual stocks may not be suitable for any particular individual investor. While A- and B-rated stocks as a group have outperformed D- and F-rated stocks as a group, individual stocks have performed differently than the group as a whole.

Past performance is no guarantee of future results.

Compustat is a division of Standard & Poors that compiles financial databases used by researchers in corporations, investment firms and universities.

The S&P 500® index is an index of widely traded stocks.

Indexes are unmanaged, do not incur management fees, costs and expenses, and cannot be invested in directly.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The type of securities and investment strategies mentioned may not be suitable for everyone. Each investor needs to review a security transaction or pursue an investment strategy for his or her own particular situation. Data contained here is obtained from what are considered reliable sources; however, its accuracy, completeness or reliability cannot be guaranteed.

(0908-4140)

Return to Top