Stop-loss orders are a fairly common tool used by investors to minimise their downside risk by limiting their loss on an investment position.
Basically, a stop-loss is an order placed by investors to sell shares once they hit a certain price. Let's say I bought shares in the fictional Company A (ASX: XYZ) for $1, but didn't want to run the risk of losing more than, say, 10% on the position. I could thus enter a stop-loss order for $0.90, which would become a market order when the stop price is reached.
While such an order is seen as a necessity by some investors, because it limits their losses if the stock in question continues to plunge below that stop price level, there are risks to such a strategy that investors need to be aware of.
A Real-Life Example of Why Stop-Loss Orders Can Be Dangerous
Indeed, the market is inefficient in that prices of individual shares fluctuate on a day-to-day basis, often without the influence of any news or reports. Individual shares can experience major swings in price in short spaces of time due to nothing more than sentiment. Greed and fear can play major roles in determining prices in the short-term.
Consider this tweet from The Motley Fool's Jeff Fischer in August 2015:
Lows hit Monday: $AAPL $92, $FB $72, $GILD $86, $V $60. No pennies. All even dollars. Why? Stop/loss orders were set there. Ouch. Just don't
Jeff Fischer (@FoolJeffFischer) August 26, 2015
At the time, share markets around the world were experiencing a bout of volatility that no doubt caused investors a few sleepless nights. Tech shares in the United States were among the hardest hit, with Apple Inc. (NASDAQ: AAPL), Facebook Inc (NASDAQ: FB) and Visa Inc (NYSE: V) hitting lows of $92.00, $72.00, and $60.00. As Jeff noted, "No pennies. All even dollars. Why? Stop/loss orders were set there".
I'd wager that some investors had set their stop-loss orders at those prices with the expectation that they'd probably never even be triggered, but more as a just-in-case. Unfortunately for them, the market met those orders before quickly rebounding, excluding those investors from the subsequent gains.
For the record, Visa closed at $96.23 overnight, while Apple and Facebook closed at $145.83 and $153.24, respectively, representing gains of 60%, 59% and 113%, respectively, since that date.
Foolish Takeaway
As tempting as it may be to set limits on our downside losses, setting stop-loss orders can force us to sell at the most inopportune time, as demonstrated by those companies highlighted above.
And don't think it only happens to companies in the United States. Long-term investors, who have ignored short-term price movements and instead focused on long-term fundamentals, have been extremely well rewarded for investing in businesses such as Altium Limited (ASX: ALU) and CSL Limited (ASX: CSL). Investors who bought and set stop-loss orders, on the other hand, could have missed out on much of those gains due to unfortunate timing.
There is a purpose for stop-loss orders, but using them also creates significant opportunity risk. Rather than employing such orders, I believe investing in high-quality businesses with a long-term objective, and ignoring short-term movements, is a much better strategy.
