This article was published on 29 August 2006. Some information may be out of date.

Readers defend stop loss orders

My arguments in my last column — that stop loss orders are a bad idea — failed to convince two readers. What about Feltex, GDC Communications, RMG, National Mail and other shares that have dropped a long way?, they asked.

Briefly, what I said was that making stop loss orders — asking your broker to sell your shares if the prices fall below a certain point — certainly helps you avoid big losses.

But if the trigger price is not far below the current price, you end up often selling at a loss — no way to get rich — and probably paying tax on your capital gains.

And if the trigger price is quite a long way below, you will take large losses on shares that may well grow fast later. Volatile shares are like that.

A good investment rule is: Never be forced to sell. But stop loss sales are like forced sales. You don’t plan them, you accept low prices, and you must then decide what else to do with the money — perhaps at an unsuitable time.

Another factor: In a sharemarket crash, prices fall so fast your broker often won’t be able to get the prices you set, but considerably lower. You may end up with no shares and little in proceeds, watching in dismay as the market recovers.

The two correspondents’ main point — that anyone who holds shares that keep falling would wish in hindsight that they had placed a stop loss order — is of course valid. But nobody knows in advance which shares will plunge, or what will happen after they plunge.

“Surely an investor should at least consider selling if a company’s outlook changes for the worse?”, says one reader. He recommends selling shares whose recent performance has been much worse than the market. “Why not sell and reinvest in a company whose stock IS going up?”

If only we knew which company that is! It might well be the one you sell.

If there’s been bad news about a company’s outlook, its price will already reflect that. Those shares are just as likely to rise tomorrow as a company that has a great outlook — because that good news will also already be reflected in that price.

Sometimes shares like Feltex quickly double, from their low base, when things suddenly improve.

Of course stop loss orders aren’t always about losses.

The other reader gives the example of Contact Energy, which rose to more than $8 but, when he wrote, was trading at less than $7. He wished he had told his broker to sell at around $7.70, as a type of profit protection. “I have many other examples,” he says.

Who knows what will happen to the price of Contact Energy? But chances are that if he looks at all his examples ten years from now, enough of them will have risen for him to be glad he didn’t use such profit protection.

He goes on to say that many books tell you when to buy shares but few say when to sell. And I agree that the selling decision is just as important — if, that is, you are a share trader.

And that, I guess, is the crux of the matter. People who use stop loss orders tend to be fairly frequent traders as opposed to buy-and-holders. And lots of research shows that the latter do better over the long term.

True, traders often do well. But that’s hardly surprising in a market that generally rises. There’s a good chance they could have done even better by not trading — avoiding brokerage, tax and other expenses, to say nothing of time and worry.

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.