Making Heads and Tails of Stop-Losses

Story Highlights:

• Stop-losses are a popular strategy for investors wanting a sense of protection against portfolio declines—especially during increased market volatility or market corrections.
• However, stocks are shown not to be serially correlated—the past price movement of stocks by itself simply has no bearing on future stock movement.
• Instead of relying on price movements or arbitrary percentage targets, investors should focus on the future outlook and underlying fundamentals of both the market and the individual stock.

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Flip a coin. Heads. Flip again. Tails. If middle school math taught us anything, it's one coin flip does not tell us anything about the next coin flip. The probability of each individual flip's outcome will always remain 50%, no matter how many heads or tails you get in a row.

Day to day stock performance is much the same. A stock may rise or fall today, but that tells us nothing about what it will do tomorrow. However, some investors see drastic declines in a stock today as reason enough to sell tomorrow. Some investors go as far as using a stop-loss strategy for their portfolios. Stop-losses are automatically generated orders to sell a security when it drops below a certain set percentage or dollar amount. For example, an investor can use stop-losses to rid their portfolio of stocks declining more than 20% without having to actively monitor stock performance.

Behavioral economists have noted investors' tendencies to focus on losses, so it's no surprise stop-losses can be a popular strategy for investors wanting a sense of protection. And in times of increased market volatility or market corrections, this sense of wanting protection grows stronger—when fears of portfolio downside crowd out the risks of missing upside.

This behavior is popular today. But there is no evidence this strategy works! In fact, research shows the past price movement of stocks by itself simply has no bearing on future stock movement. Stocks are what a statistician would describe as not auto-serially correlated. When a stock moves in any given direction, the odds are about 50-50 it continues in that direction or reverses trend—much like our coin toss. So if a stock declines 20% today, the chance it falls tomorrow is as great as the chance it rises (even rising by a lot) tomorrow.

Look at it another way: If you knew a stock dropping 20% signaled more declines in the stock's performance going forward (and conversely a stock rising indicated more increases), then you'd know exactly which stocks to avoid and which to buy. If this were possible, we'd all be billionaires driving Ferrari F430s! In reality, just as often as not, winners turn into losers and losers become winners. This is why heat-chasing and momentum-buying strategies are never good for the long-term.

Act Fast and Kiss Your Returns Goodbye
By Brian Richards, The Motley Fool
https://www.fool.com/investing/general/2008/03/19/act-fast-and-kiss-your-returns-goodbye.aspx

The decision to get in or out of a stock should not be driven by arbitrary price targets but by the stock's future outlook and underlying fundamentals. Perhaps outside market factors, like political change, are temporarily depressing a stock's price or perhaps a lagging company has discovered a new competitive advantage.

Fate is never a good investment ethos, so leave coin-tossing strategies like stop-losses out of your plans. Stick with patience, wits, and fundamentals. Have a great holiday weekend.