Do Stop-Losses Actually Stop Losses? Fisher Investments’ Founder, Ken Fisher, Debunks the Belief

Transcript

Ken Fisher:

Do you realize how well you would have done, I know you do, if you had bought something like Amazon early on? But if every time they had had in their evolution a 10, 15 or 20% drop, and you'd use that number as a stop loss and you would have gotten out of it unless you got back into it at the right time, do you realize how much you would have missed?

Every month I do a video covering one of the little sections in this book Debunkery of mine—this whole book. One of the things I like about the book is that all of the sections in it that debunk some common myth about investing a long time ago are actually still valid. The numbers just change. And one of them is—and I always like to, you know, go to the chapter itself and show you—is this one. What I called 'Bunk Number 12: Stop losses Stop losses.'

Now stop loss, as you may well know, is the concept that when you buy a stock —if it falls a certain amount, like 15 or 20% or something— you just automatically sell it, that it protects you from a bigger loss. And at one level that's true and another level it's not. Stop losses actually create losses. Stop losses really stop gains. Let me take you through the how and the why of that, as I did in the book. The fact is, if you just get enough of these videos on this thing, you don't ever need to read the book. You follow that?

The fact of the matter is, that mechanical device is set almost always at some arbitrary number, like if the stock goes down 10% or 15% or 20% or if the whole market's down 10%, or 15 or 20%. But we have a very long history of stock prices, and we got computers and they actually mostly are good at doing calculations that are pretty accurate. The calculations are in. It's been proven for a long time that any given price movement by itself tells you nothing, nada, zero about future price movements of that security. That it falls a certain amount, or rises a certain amount or doesn't tells you nothing by itself about what will happen next —the next day, the next week, the next month.

So before I get into more reasons why stop losses are bad, let me just make the point that simply, if you engage in transaction costs with a random outcome after them, you will overall—as you do it over and over and over and over again— simply lose money because you'll get random outcomes, less the transaction cost. You follow that? Now you'll say, "Yeah, but brokerage costs aren't that much these days. That's true. But the bid-ask spread is more than that. The biggest cost when you run a transaction is not the brokerage but the bid-ask spread. And if you do a lot of stop losses over time, you then get to the question of after you've done them—getting a random outcome— unless what you replace them with is better than what you got rid of, you lose money. Because you got a random outcome, meaning the price doesn't change but the transaction cost comes out.

So let me give you an example that leads you to where it is that you would need to be to make this work for you. A really common level—because they are always some number, like they're always round numbers. Like, "I do stop losses when they're at 10%," or "I do them when they're at 15%" or—nobody does stop losses at 13.74%. You follow that? I mean, it's always some random number. But it wouldn't make any difference whether it was some random number or some little detail number. A common one is 20. 20 is supposed to be one of these ones that's going to protect you from big drops. Think about that.

If you did it for the market as a whole, a stock market correction within a bull market is normally defined as a drop of more than 10%, but less than 20%. So it's true that if you bought and stopped loss at 20% by selling out when the market had fallen 20%, you would keep yourself from having stocks when they went down by more than 20%.

Think about that last year when the US stock market—from its peak—went down into a bear market but only by a little over 20%. What did I do? Well, if you think about it, market falls from the bottom. It then rises. Those last few percent are recouped in just a relatively few weeks. So unless you're a really good trader, if you sold out at 20, you'd be buying back at a higher price later. And if you buy back at a higher price later, you cost yourself. And if you got out at 20 and you just stayed in cash. You cost yourself.

Now remember the market falls, then the market rises. There's a fairly narrow time on those last percents. The fall doesn't by itself tell you anything about what's going to happen next. But in that case, it would have protected you from a slight decline of a few percent. But unless you're a really nimble trader, you wouldn't know when to get back in.

The real question with the stop loss always is when do you get back in? What do you get back into? If you're good enough to have timed last year that well, you don't need any advice from me about anything and almost nobody is that good. To time it that well—because if you could time it that well, you wouldn't have needed the stop loss in the first place because you would have seen that up above you needed to sell. You follow that?

If you're a really great timer, you don't need a stop loss to do this. If you're a really great timer, you get out when the market's up here because you've got some special signals that you know that tell you when to get out that are really good and effective. And then you get back in with your other special signals to tell you when to get back in. But let's say you just own a given stock, "Stock X." It falls by that level that you set your stop loss at 10%, 15%, whatever it is. And then what do you do? Do you buy it back later at a price? How do you know when? Do you buy a different stock in its place? How do you know it won't fall another 20%? And then you sell it, and then you buy another one and it drops 20%. You just went down 20 and 20 and 20, which is a lot more than 60—compounded. How did that help you? You follow my logic here?

Let's go to the other extreme. Let's say you set the stop loss at—this is just going to make the example easier— let's say you set the stop loss at the stock falling by 1%. Will you be selling everything you ever bought? Pretty commonly. Unless as soon as you bought it, it just went straight up. Now let's do another example. You buy the stock at 100, it falls. You set the stop loss at 20%. Again, wouldn't matter what you set it as. Let's just, for this example, say you set it at 20. Well let's not, let's say you set it at ten. That's fine by me I don't care. So you set it at ten and it drops by 10% . From 100. You're down to 90. It's functional.

Now, is it different? If you bought it at 80, it went to 100 and then it fell to 90. What do you do then? Do you sell at 90 because you bought it lower? Because if you hold most stocks over the long term, there's going to be a lot of this. And if you sold at 90, I go back to the question before: What do you replace it with? Do you realize how well you would have done, I know you do, if you had bought something like Amazon early on?

That's just a single example. But there's many and you know that. But Apple, Tesla if every time they had had in their evolution a 10, 15 or 20% drop, and you use that number as a stop loss and you would have gotten out of it unless you got back into it at the right time, do you realize how much you would have missed? If you did with the whole stock market, and you did that, unless you could time it really well do you realize over time how much you miss? There's the loss you get from buying something that goes down and you realize the loss. There's the loss you get from opportunity cost missed over the long term. And since stocks mostly rise in the long term overall, the stop loss costs you more than that transaction cost on a random basis. And there you're losing real money. You're losing real money that you need in the long term.

So I hope I've made it really clear to you why stop losses may feel good at the time. They help sell you out of the market partway into a bear market, for example. But that feeling good actually ends up being expensive to you, because it's random. What happens the moment after you did the stop loss? And you really don't want to base your investments on randomness. Thank you very much for listening. I hope this was useful. I've probably annoyed some of you. I kind of presume I do that a lot with a lot of my videos. But the fact of the matter is, if you deploy stop losses regularly, stop losses by themselves just create losses and stop gains. Thank you for listening to me.

Voice of Ken Fisher:

I very much hope you enjoyed this video as part of my series on debunking common market myths. To watch more videos like this, click the link on the screen and make sure to subscribe to Fisher Investments' YouTube channel. Thanks so much for listening to me.