My brother-in-law and I were talking about investing recently and I told him the big swings in prices make me a bit nervous. He told me that “his guy” uses “stops” to make sure he doesn’t lose money. What’s up with this and how do I do it?
There are advantages and disadvantages to using orders in your portfolio. Yes, using some version of a stop order can limit (or possibly prevent) your losses, but there is a potential danger lurking in the shadows, too. Don’t worry. I’ll get to it.
First, let’s talk about stop orders. There are two types to be familiar with. Stop-loss orders and stop-limit orders. They names sound the same, but how they function is notably different. Also, stop orders can be used when you’ve “shorted” a stock, but that use is beyond the scope of what we’re talking about today.
A stop-loss order works as such: Let’s pretend you bought stock XYZ at $50/share. The markets are good and the price has risen to $75/share. Congratulations! You’re thrilled with the growth, but you want to make sure you keep some profit if the markets turn south. You could place a stop-loss order on this position. Let’s continue to pretend and you place a stop-loss order on your XYZ position at $60. This means if the price of XYZ goes down to $60 an automatic sell order will be made for your position. A stop-loss order doesn’t mean that you’ll sell your entire position at $60, though. If the price is falling quickly, you may end up selling your position less than $60. That’s the downside. The upside is that the position will get sold. A stop-loss promises execution of the order, not the price you get.
A stop-limit order, however, can promise the price that XYZ is sold at. We’ll use the same example as above, bought for $50, price is now $75, stop placed at $60. The “limit” part of the order will allow you to put a minimum price you’ll accept for your stock when you sell it. We’ll say you set your limit at $58. Sounds good, right? You’re in complete control now. Well, almost. If the price of XYZ is falling quickly and your stop is hit at $60 triggering the sell, there is no promise that all of your position will be sold before XYZ falls past $58. That means you could sell all of your position, or just some of your position, depending on the amount of XYZ you own, the size of the market for XYZ, and how quickly the price is declining. What happens if you aren’t able to sell your entire position? You’ll continue to hold XYZ until the price rises back up to $58 when the rest of your position will try to be sold again. So, a stop-limit order can promise the price you get for the position, but not the execution of the entire order.
You may be thinking, “Ok. I can deal with that. What’s the danger in putting stops on all of my investments?”
Getting out of the market is one thing, but getting back into the market is completely different. If you’re placing stops on positions to protect yourself in a worst case scenario, there is some bit of comfort there. The difficult part will be knowing when to reinvest the money in the future. How will you determine when that time is? More importantly, will you be able to stick with your plan to reinvest once that time arrives? Ask nearly any financial advisor how well market-timing works. They’ll say that, in theory, it’s great. They’ll quickly follow up with, in-practice, it’s a disaster. Why? We’re human, that’s why. We’re naturally wired to avoid situations that could cause us pain and to avoid perceived danger. If (when) the market falls into the next recession, what will many investors want to do? Take their money out of the market. What should investors do? Leave it where it is and continue to invest new money as the market falls. Investors get more for their money as prices decrease and they’ll be much better off when the market recovers if they can stay the course. If the investor decides to sit on their cash during the decline, how much of a recovery needs to happen before they feel comfortable reinvesting? When will the investor be convinced that it’s “safe” to reenter the market? It’s a terribly tricky question, and one that doesn’t have a concrete answer.
Another potential pitfall of using stop orders is a situation where the stops are triggered, your positions sell, and then the market turns and begins increasing. You’ve been cut out of participating in the recovery because your stop kicked you into a cash position. Now, if you want to own XYZ again you’ll need to repurchase it at a price that is higher than what you sold it for. Plus, you’ve potentially created a taxable event for yourself depending on the type of account this occurs in.
Do stop orders have a place in some portfolios? Possibly. I think stops are best used in conjunction with a financial advisor who will help mitigate some of the natural emotion of investing and help you keep a level perspective. Experienced investors could also potentially benefit from strategically used stops with specific stocks they own or are speculating with.
If you’re working with an advisor and are interested in how stop orders might benefit your situation, contact them to discuss the option. This will give you and your advisor a chance to revisit your investment strategy, your risk tolerance, and if these types of orders might be a good fit for you. If you’re an experienced individual investor but aren’t sure if stop orders have a place in your strategy, do some additional research and consider talking to a professional if you need some perspective.
Stops can be an effective financial tool, but it’s important to understand the advantages and drawbacks they offer before employing them.
Damian is the lead Financial Concierge on Your Money Line, the financial help line serving all Pete the Planner® Financial Wellness clients. Damian is a CERTIFIED FINANCIAL PLANNER™ professional and loves answering your money questions. Despite sharing a last name and sense of humor, Damian and Pete are not related.