This article was published on 14 December 2004. Some information may be out of date.

Stop loss strategy can in fact stop you from winning

A paragraph in a recent article in some of the newspapers that run this column caught my eye.

“If you feel a bit more daring, yet want to retain a backstop strategy,” it read, “buy shares and sell them if they drop below 5 per cent of the purchase price. Sell once they increase above 10 per cent of the purchase price.”

Such “stop loss” strategies are often recommended, and at first glance they sound like winners. You’ve got a good chance of getting a 10 per cent return, they seem to be saying, and the worst that can happen is that you’ll lose 5 per cent.

But I’ve got several worries about them:

  • It’s not uncommon for shares to drop 5 per cent or rise 10 per cent over quite a short period.

    If you used this strategy, you would be in and out of the markets quite frequently. That means you would be paying lots of brokerage, which eats into returns. And you might also have to pay tax on your capital gains, which takes out another big bite.

  • You would often find yourself wondering what on earth to do with the money now that you have sold.

    It’s not a good idea to sell an investment unless you have a better place to put the money. Too often, it ends up sitting in the bank for months, earning a lot less on average than it would have in shares.

  • Okay, you might say, let’s set the numbers further apart to avoid such frequent trading. You might sell at minus 10 per cent or plus 20 per cent.

    That would be an improvement, but when markets are volatile you would still trade often. And you would now be taking considerable losses, at 10 per cent.

    There’s no magic number at which you can avoid frequent trading and yet limit your losses to only minor amounts.

  • Perhaps most importantly, strategies like this sound fine, but they are psychologically difficult.

    If a share price falls, we usually tell ourselves that it’s just temporary, and we’ll hang about until it rises again. And often it does, indeed, go back up. Bailing out while it is down feels wrong.

    Similarly, if a share rises considerably, we tend to tell ourselves we are on to a good thing, and find it difficult to sell then, too.

    You could get around this by instructing your broker to sell when your shares reach a certain price. But I would be surprised if you don’t sometimes regret doing that.

These arguments are even more valid when the whole market moves strongly up or down. With the suggested strategy, you might find yourself selling all your shares in a day or two — a move that might make you extremely uncomfortable, and rightly so.

If the market is booming and you bail out, you might miss some great gains. If it’s falling fast, you are probably better to ride out the fall. Often markets rebound fast. Sometimes it takes ages, but they do eventually come back.

Research repeatedly shows that share investors do best by buying a portfolio of at least 10 — preferably 20 or 30 — shares in different industries and company sizes. The shares should also be based in different countries, unless you are also investing in an international share fund.

Then forget about trading strategies. Hold the shares for many years, through rising and falling markets.

Sell only those shares that have done so well that they now dominate your portfolio, and then sell only some of those holdings, just to restore balance.

Mary Holm is a freelance journalist, a director of Financial Services Complaints Ltd (FSCL), a seminar presenter and a bestselling author on personal finance. From 2011 to 2019 she was a founding director of the Financial Markets Authority. Her opinions are personal, and do not reflect the position of any organisation in which she holds office. Mary’s advice is of a general nature, and she is not responsible for any loss that any reader may suffer from following it.