These signs say stop using stop-losses. Photo by Kiyoshi Noguchi/Getty Images.
On February 26, 2016, stop-losses will get a little bit harder to deploy. Last week, you see, the NYSE announced it will no longer accept stop orders-instructions to sell or buy a stock once it reaches a certain price. Included in this category is the infamous stop-loss, which many believe is a sure-fire way to limit portfolio declines. In practice, though, these orders very frequently lock in losses, reducing overall returns. In our view, we'd humbly suggest investors should voluntarily cease and desist from using stop losses, regardless of what the exchanges and brokers do.
The change follows erratic swings on August 24, which triggered many stop-losses-to investors' detriment. Several retail brokerages asked the NYSE to investigate whether stop-losses actually ... stop losses. This review triggered the change-the NYSE concluded investors largely misperceive how they work. In announcing the change, NYSE COO Stacey Cunningham said, "The circumstances around stop orders have changed. A lot of investors use stop orders thinking it's an insurance policy. The perception is they limit losses, and that's just not the case," and the NYSE wants to "raise the profile of the risks associated with this order type."
In our experience, Cunningham is spot on. There is a big gap between the common "stop-loss" name and the actual mechanics. For example, let's say an investor places an order to sell a stock if and when its price falls to $50. Once the stock hits $50 or below, the stop order becomes a market order, and the stock is sold at the next available price, which might be higher or lower than $50. As August 24 shows, sometimes much lower.
That day, some widely owned blue-chip stocks and ETFs plunged over 20% at the open. The big declines triggered many stop-losses, but prices rallied sharply off the lows as the morning went on. Hence, some investors sold at rock-bottom prices that existed only momentarily, missing the recovery that arrived mere minutes or hours later.
The NYSE correctly concluded investors' use of stop orders caused realized losses, the opposite of why investors use them in the first place. This isn't that isolated a scenario: The same thing happened on May 6, 2010-the now infamous "flash crash," when stocks fell -6% in 15 minutes, only to rebound sharply by the close. Investors with stop orders ran the risk of being stopped out near the lows.
This isn't the only issue, though. Since stock prices don't always move in a gradual, linear, step-by-step manner, stops won't shield you from a stock plunging far below the price you saw as a floor. For example, let's say you owned shares of widget maker XYZ. XYZ is trading at $50, and you don't want to lose much in it, so you slap a stop-loss on at $45. That night, you shut your eyes thinking the most you could lose is 10%. But you would be wrong. Let's say hypothetical news hits after the closing bell one day that XYZ is embroiled in the Great Widget Accounting Scandal of 2015.[i] The next day, it opens at $15. Your stop-loss-set to trigger slightly below the prior day's price-will execute at a far-lower price. This doesn't need to be an overnight thing, either. Such scenarios also happen intraday, for a variety of reasons-and with no advanced warning. Investors who have open stop orders probably won't have time to cancel them before the stock's price blows through their stop level.
Philosophically, stop orders don't make sense because past price movements have no bearing on future performance. Yes, some stocks continue falling after dropping enough to trigger stop-losses. But there are countless other examples when stocks fall 10%, 15% or 20% (or whatever arbitrary stop-loss threshold investors choose) and then turn around and go back up, often surpassing their prior peak. And, heck, even if a stock keeps dropping after you to sell it, there is no assurance whatever you buy with the proceeds won't drop too-possibly triggering a stop-loss as well-compounding your losses. The cycle can theoretically continue until you've lost almost everything.
What's more, if you place stop-loss orders on all your stocks, and most or all of them get executed during a sharp market decline, and you don't immediately reinvest, the market can zoom higher while you're all (or mostly) in cash. This high opportunity cost is money lost. This likely happened to some investors during the recent market correction. Making matters worse, stop-loss orders may well have intensified market volatility during this period. A study by BlackRock concluded stop-loss orders likely exacerbated August 24's price swings, claiming falling prices triggered stop-loss orders, causing shares to be sold, resulting in further price declines, triggering more stop orders, etc. A classic negative feedback loop. Now there is no real way to prove this[ii], but it has some plausibility when you consider there wasn't much actual, visible panic that day-cool heads seemed to prevail. Automated trades could explain the apparent dissonance.
But whatever they do to volatility, stop-losses boost trading costs. They could also trigger unwanted taxable events, like short-term gains (taxed at a higher rate than long-term gains). If you need to withdraw funds from your portfolio to pay these taxes, you will miss the future growth this money would otherwise have achieved. Stop-losses also open you to even more behavioral errors. When will you reinvest the cash proceeds from stop-loss-triggered sales? What if you wait for the market to fall further, but it keeps rising? How do you pick what to buy?
Stop-loss proponents can take some comfort in the fact a dozen other venues currently accept them, mostly dark pools-private exchanges or forums for trading securities. So if you want to run the risk of putting an arbitrary market order under your position, ready to execute after a stock declines, you still can. It is also possible broker-dealers-in an effort to accommodate investors who still want to use stop orders-might still offer them, creating an algorithm to hold orders on their books until the stock reaches the stop price, then submit market orders to the NYSE or NASDAQ, which doesn't accept stop orders either. Then again, they may not. After all, few if any professional investors actually use stop orders, and NYSE data show they account for less than 0.3% of volume. If you are part of that 0.3%, we'd humbly suggest even if exchanges will let you, you should cease stop-losses now, lest they arrest your portfolio's growth.
If you would like to contact the editors responsible for this article, please click here.
*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.