This article was published on 15 August 2006. Some information may be out of date.

Stop loss orders a dead loss

A reader writes that he is concerned about my advice in my last column.

“Your two rules of share investing are to a) diversify (i.e. neutralize returns), and b) not sell when the market bombs,” he writes. “One would have hoped you would have added a third — enter a stop loss to avoid catastrophic loss if/when the market does bomb.”

Not in my rulebook.

For the benefit of others, if you make a stop loss order with a share broker, you ask him or her to automatically sell your shares if they fall by more than a certain amount.

It sounds like a great idea. As our reader says, you can avoid huge losses. But, as economist Milton Friedman said, there’s no such thing as a free lunch. With stop losses you can ruin your chances of doing really well with share investing.

Let’s say you own several shares, preferably more than 20 to get good diversification. And you tell your broker to sell any of them if their price falls more than 5 per cent from the purchase price.

The trouble is that this is quite likely to happen, especially in the first year or so. You’ll be paying lots of brokerage. And before you know it, Inland Revenue might take an interest in your frequent trading.

If you have to pay tax on your capital gains, that hugely eats into your profits. A $10,000 investment with a net annual return of 9 per cent grows to $56,000 in 20 years. Cut that to 6 per cent because of 33 per cent tax, and you get just $32,000.

To avoid frequent trading, you might decide to switch to a stop loss if the price falls more than 10 per cent. But then another problem arises. You will end up taking quite a few considerable losses — and often on shares whose prices later rise, sometimes to lofty heights.

The very shares most likely to fall considerably are also the ones most likely to do extremely well. They are riskier, and therefore tend to bring in higher average returns.

Paper losses — when your share price falls but you ride it out — don’t matter. But realised losses — when you sell at a low price — certainly do.

Move to 20 per cent, and you will suffer fewer realised losses. But they will be big losses. You will be buying high and selling low — an investor’s nightmare.

There’s another issue here, too. With stop loss orders you make unplanned sales. You probably won’t have an immediate idea of what to do with the money, and it may languish in a bank account earning a low return — perhaps while the share rebounds.

If the whole share market dives, you might suddenly end up with no shares at all and lots of money in the bank. Or, worse still, not a lot of money in the bank. In a crash, your broker won’t be able to get you 5, 10 or 20 per cent less on all your shares. On crash days the market moves so fast you might end up with much less.

Most people prefer to plan their share sales.

On reflection, I should have added a third rule of share investing, but not about stop losses. It should have read: Always buy shares with the intention of holding them for at least ten years — regardless of what the markets do.

History shows that those who invest in a wide range of shares for a decade or more almost never lose money, and most do very well.

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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.