In the investment community, many rules of thumb are taken for granted. Buy low, sell high. Don’t put all your eggs in one basket. Cut your losses short; let your winners run. Often offered without detailed analysis or support, these recommendations are typically followed by investors in faith. Let’s consider the stop-loss order. Investing books, articles and magazines commonly refer to the stop-loss it as a risk management tool. The idea is that going without stops is like driving a car without a seat belt – risky. On the surface, the logic of saving a losing trade from losing even more money appears impeccable.

Upshot

With the volatility in today’s market, a stock almost always hits the stop-loss. The effect of this is to decrease returns while having a negligible impact on risk. Instead of protecting against a loss, the investor has turned losing into a foregone conclusion. In many instances, stocks seem to go up right after the stop is hit, and the would-be cautious investor has been sold out. In essence there is no simple and conclusive way to rely on stop loss as protection on the downside, nor artificial objectives on the upside. On the other hand, wide trailing stops have been proven effective in avoiding momentum on the downside, particularly in bear market by preventing extended losses.

Sell Rules

I have found that a set of straightfoward sell rules work well: have the fundamentals of the company changed, has the stock become overvalued relative to its growth, or has the stock price broken a wide trailing stop? As long as the fundamentals remain the same, or get better, stick around to see what happens- you could be pleasantly surprised.