[Editor's Note:  We continue our popular Pro/Con series today with a piece on using Stop-Loss Orders.  The Pro/Con approach works well with controversial topics in medicine and in finance.  I also use the approach when I simply disagree with an otherwise well-written guest post.   Writing for the Pro side today is Alex Foster, a fee-only financial adviser at AF Capital Management in Georgia.  I'll be taking the Con side.  We have no financial relationship.]

Pro – Why I Use Trailing Stop-Loss Orders

By Alex Foster

I am a believer in the benefits of using low-cost index funds for mostly passive investing.  I say mostly passive because I also use trailing stop ladders to protect against outsized losses in a bear market.  Trailing stops reduce downside risk significantly while leaving the upside potential for gains wide open.

Trailing Stops Better Than Fixed Stops

A trailing stop takes a regular stop-loss order to another level.  Investors can use a stop-loss order to sell ETF (or stock) shares at a specific price if their investment falls below their loss limit.  Rather than picking a static stopping point for an order to sell shares, a trailing stop automatically moves the exit price higher as the ETF’s price increases as either a percentage or dollars and cents basis.  This dynamic movement allows an investor’s loss limit price to move higher as the ETF ascends.  For example, if an investor buys SPY (an S&P 500 index ETF) for $150, but doesn’t want to lose more than 10%, the trailing stop would automatically sell the shares if SPY dropped to $135.00.  If SPY rallied to $170 before correcting 10%, the trailing stop would raise the exit price to $153.00, still 10% below the intraday high for the ETF, but $3.00 higher than the purchase price.  This rise in the potential exit price allows investors to lock in profits during a bear market, but without having to sell shares before the bulls’ run has finished.

Gapping Can Be An Issue

This approach has risks.  An ETF can drop through a planned exit price (especially if it gaps lower at the market’s open) and initiate a sell order below an investor’s planned exit price.  Making matters worse, the ETF can reverse off of that opening low and the investor will have sold shares at the bottom of a small dip.  This unwanted trade is one of the reasons trailing stops should not be set too close to an ETF’s normal ebb and flow range.

Minimize Gapping With A Trailing Stop Ladder

The solution for such a mishap can be managed with a trailing stop ladder.  As the name implies, a “laddered” approach takes smaller steps rather than making the investor “jump” out of a position completely in a single trade.  A trailing stop ladder can be staged in a variety of ways to suit each investor’s needs and risk tolerance.  I prefer to use percentages rather than dollar amounts for the trailing stop ladders I build.  An order using a percentage for a trailing stop adjusts to price increases better than an order using a fixed amount.  For example, a 15% correction from $150 is a $22.50 drop in price, but by the time the ETF reaches $200, $22.50 is only equal to an 11.25% drop in price.

The first trailing stop can be the most important rung in the ladder in determining its success and avoiding being whipsawed with unnecessary trades.  For example, an investor can have the first trailing stop set to trigger after a 6% correction from the intraday high followed by further trailing stops at 8%, 11%, and 15%.  As each trailing stop is triggered, the percentage of assets from the next ladder should increase.  In this example, after a 6% decline, 5% of the holding would sell.  Intentionally, this is a very small amount and reduces the risk of quick reversal leaving the investor underinvested.  The next trailing stop should be 10% of the total account value (including cash value), followed by 15% and then 20%.  I don’t tend to run trailing stop ladders past 50% of an account because I find it hard to reason being less than 50% invested for most long-term investment scenarios.

 Minimizing Whipsawing

The risk of being caught underinvested in a reversal is reduced by ramping-up the percentage at each descending level.  An account has very little missed upside when only 5% of the assets are sold at the first level and then the ETF reverses to new highs before the investor buys back in.  If the ETF falls another 2% and the second trailing stop is triggered, the investor will be 15% in cash, but with losses reduced due to the first sale that removed some exposure.  Any reversal in the ETF’s price from this second sale does not cost the investor a dollar-for-dollar missed opportunity due to the cushion created from the first stop loss order.  If the ETF’s ascent exceeds the price of the first stop loss order, the investor should reinvest and start the process over again with the first two rungs of the ladder.  The other two stop orders can remain in place in case the ETF resumes its slide.  The total upside missed from a reversal after the second trailing stop would equal 2%, but of only 10% of the account.  In other words, the investor would have only 0.2% of missed opportunity.

The benefits increase as the ETF continues to fall.  For the next 3% decline (11% in total), 15% of the account does not lose a dime and the buffer from a price reversal is greater, even after the account is 30% in cash from the third rung of the ladder.  By the time the market has fallen 15%, the account is slightly greater than 50% in cash and further declines cost the investor half of what they would have cost if an unadjusted buy and hold approach was used.  The account should have slightly more cash than the amount invested because the cash portion did not incur losses during the correction.

Conclusion

Investing is a balance act of risks and rewards.  Investors can reduce downside risks while maintaining the potential for rewards available by using a trailing stop ladder. The benefits of using a trailing stop ladder outweigh the negatives.  While laddering out of a position with staggered trailing stops does not eliminate risks, it does reduce the size of losses significantly during a bear market.

A trailing stop ladder is suited for investors who understand the market tends to move higher over multiple decades, but this long-term upward trajectory will be interrupted with multiple 10, 20 and 30+% corrections along the way.  This mindset, while knowing investing passively can prosper over a longer period, is prone to emotional trading due to the fear of the next unavoidable correction.  By removing emotions and automatic selling well before the next 30-40% bear market, the investor is able to relax and sleep more soundly while staying long equities the majority of the time. The idea of mostly passive investing can sound simple, but the best investors will take the time to write down their plans and stick to it.

 

Con – 6 Reasons I Don't Use Stop-Loss Orders

By The White Coat Investor

Stop-loss orders are one of those investing techniques that sound wonderful when you initially learn about them, but turn out not to be such a good idea once you understand them.  Even the name calls to you like the ancient Sirens.  “Stop-loss!”  What's not to like?  Who wouldn't want to stop their losses?  What a wonderful promise!  You can invest and ONLY get the gains!  However, like active management and market timing, the devil is in the details.  Here are six reasons I don't use stop-loss orders.

1) Additional investment costs

The stock market is a little bit like a casino in that the house always makes money.  As a general rule, the less you walk into a casino, the better you do.  The analogy breaks down a bit as on average you lose money gambling but make money investing, but nonetheless, studies are quite clear that the fewer transactions you make (fewer times you go into the casino), the better you do.  There are behavioral factors that affect this, but transaction costs are also a significant cause of this performance gap.  Every time you buy or sell an investment on the open market you will at a minimum pay a bid-ask spread.  You may also pay commissions or other fees.  You can do what you can to minimize this effect, but it still exists.  When you use stop-loss orders, you will make more transactions than you otherwise would, and that's going to cost you.

2) Additional taxes

If you are investing in a taxable account, there is an additional cost, that of taxes.  When you buy and hold a security in a taxable account, you pay taxes on the dividends at a lower rate.  When you eventually do sell, you can pay taxes on those gains at the lower long-term capital gains rate.  You might even get out of those gains completely by donating the shares to charity or getting the step-up in basis at death.  Tax-loss harvesting can further lower your tax bill.  Using stop-loss orders, however, is almost surely going to incur some significant gains taxes, and to make matters worse, there's a great chance you'll be paying those at the much higher short-term capital gains rate, which is your regular marginal tax rate.  Lowering your investment return by increasing your tax drag is not a recipe for investing success.

3) Additional complexity

When you decide to use stop-loss orders, you've introduced significant complexity into your portfolio.  Advisers love complexity.  Making investing appear complex causes clients to hire them more often and pay them more.  Additional complexity has a cost.  It may be the cost of hiring an otherwise unneeded advisor.  It may simply be the cost of your time, logging in to your accounts more often, following the market more closely, or even laying awake at night.  Once you have decided to use stop-loss orders, you have to decide where to place them.  Surely some stop-loss orders are better than others.  It gets even more complex if you use stop-loss ladders.

I prefer not to even look at the markets.  I have found that writing my monthly newsletter forces me to look once a month, and that is far more often than I was looking before I started that.  Aside from Peer 2 Peer Lending, I generally make one or two transactions a month, and that's only because I've elected to use ETFs instead of mutual funds in my 401K in order to save on fees.  Otherwise I could go for months without knowing or caring how the overall market is doing.  Using stop-losses eliminates one of the greatest benefits of using a fixed asset allocation, the ability to ignore your portfolio for long periods of time.  I don't plan to use the money I have invested in my retirement portfolio for 2-5 decades.  I could not care less what it does over the next day, month, or even year.

Stop-Loss Orders Are A Form Of Market-Timing

Aside from additional costs and complexity, the main problem with investing using stop-loss orders is that it is really market-timing in disguise.  Market-timing is buying a security when you think it's going to go up, and selling it when you think it's going to go down.  It turns out that market-timing is really hard.  Very few people can do it successfully over the long-term, and almost no one can do it once you take into account the additional costs.  Like Mike Piper, I prefer to be agnostic when it comes to what the market is going to do in the future, especially the short-term future affected by a short-term technique like stop-loss orders.

If you set a stop-loss order to sell when the value of the security goes down 10% (whether it is a fixed stop-loss or a trailing stop-loss, the same issue applies), you're basically saying that you believe that the market is going to go down from there.  We could argue all day about whether it is more likely that the market goes up from there (return to mean) or down from there (inertia/trend-following), but the truth is that we really have no idea whether the market is going to go up or down.  If it goes down from where you sold, you win!  Unfortunately, if it goes up from there, you lose.  Not only did you pay the additional investment expenses, additional taxes, and additional time requiring to implement and maintain the system, but all was for naught as you ended up buying high and selling low anyway.  Repeat that enough times and you'll never reach your investment goals.

Also consider what happens even when you “win” with a stop-loss order.  Say you buy a security at $100.  It goes to $103, then drops to $98, so you automatically sell it.  Then it drops to $93.  Do you buy it?  What about at $88?  Or $78?  Winning at market-timing requires that you “win” not just once, but twice.  You have to know when to get out AND when to get back in.

Beware of Getting Whipsawed

The term “whipsawed” refers to a common phenomenon for those using stop-loss orders.  JP Morgan was famously asked about what stock prices were going to do in the future.  His response?  “They will fluctuate.”  It doesn't take much of a student of the markets to realize he was right 100 years ago and he's still right today.  If you set a stop-loss order at -5%, and the price for that security moves back and forth 5-10% over the day or over a few weeks, you'll get whipsawed.  You'll log in to your account and find that a security you bought at $100 is now at $105, but then you'll realize you sold it at $95.  Now what?  Do you buy it back at $105?  There's a plan for success.

Watch Out For Gapping

“Gapping” refers to a phenomenon when the price of your security goes right through the price of your stop-loss order without you being sold out of it.  Sometimes this happens at market opening, when the price simply opens much lower than when it closed the night before, but often times gapping occurs in times of severe market volatility, exactly those times when you want a stop-loss order to protect you.  There is nothing magic about a stop-loss order.  There still has to be a buyer at that price for you to be able to sell.  In times of severe market volatility, there simply aren't buyers at any reasonable price. So you might set a stop-loss order at $95, and find out it actually sold at $78.  That increases the probability of you buying high and selling low and getting whipsawed.  When the market plunges, I prefer to get paid as a provider of liquidity (buying when there's blood in the streets) rather than paying to be a demander of liquidity (following the herd out the door.)

Stop-loss orders sound wonderful.  But once you understand their downsides, you'll likely prefer a simpler, cheaper, buy-and-hold fixed asset allocation investing approach.

 

Rebuttal – Alex Foster

Costs Can Be Minimized

Investment costs can add-up quickly with frequent trading, but using a stop-loss ladder that begins outside of an ETF’s normal range of fluctuation will reduce the number of trades per year to only a few.  Discount brokers charge less than $10 per trade and can be under $5 in some cases.  The benefit of stopping a loss of $1,000s or $10,000s is worth spending $30-60 per year.  Taxes are another cost that is unavoidable with any profitable trade.  However, based on the opposing view, stop-loss orders should only result in losses, so these would be tax write-offs.  In reality, these trades are taxable events on profits in most instances, just as rebalancing a portfolio every six to 12 months is a taxable event.  That said, I can agree the benefits are greater in a tax-deferred account.

Stop-Losses Aren't Market Timing Any More Than Rebalancing

Market timing is based on opinion while a planned stop-loss ladder is based on pre-established set intervals that do not waver based on news headlines.  These trades are the same as annual rebalancing that sells based on the calendar even if the bull market is in full force still.  The probability of missing a reversal is minimized if an investor begins to ladder back into exposure at a 25% correction.  According to Ned Davis Research, the average bear market since 1900 has hit the market with a 31.5% loss.  An investor who does not want to miss the market bottom can begin laddering back in with new limit orders to buy once the ETF corrects 25%.  Using the example above, the investor would be 50% in cash and will have missed the previous 10% of losses for half of the account’s balance in addition to the smaller percentages saved from each level since the market was down 6%.  100% of the remaining cash can be reinvested in a laddered approach such as buys using 15% of the maximum cash balance at 25% down, 20% at 27%, 25% at 29% and 40% at 31% down.  The piece of mind gained with a stop-loss ladder quickly outweighs the time cost associated with building this protection.  On a $1 million portfolio, I’d rather save $150,000-250,000+ every four-five years using a stop-loss ladder at the cost of a few mistimed trades.

Rebuttal – The White Coat Investor

Always A Scenario When Any Stop-Loss Program Works Out Poorly

There is potential for a trailing stop-loss program (and a graduated approach back in to the market) to save you tons of money, but it requires the next bear market to be at least roughly outlined in advance.  The less accurate your estimate, the less profitable the program will become (and it doesn't take much loss of accuracy for the program to be not profitable at all.)  No matter what plan you draw up, I can come up with a possible market situation that will make it worse than a buy-and-hold plan.   For example, if this was your plan:

• 6% Loss – Sell 5%
• 8% Loss – Sell 10%
• 11% Loss – Sell 15%
• 15% Loss – Sell 20%
• 25% Loss – Buy it all back

then you'll do poorly if the market only drops 18% before rising back to where it was before.  You've sold half of your portfolio “low” and are now faced with a decision about whether or not to buy it back “high”.  Even if the security drops 25% and you start buying, you still need two different plans – one for what you do if the price drops further and one for what you do if the price rises.  Now, multiply all these plans by 5 or 10 different asset classes.  It doesn't seem quite so simple or cheap now.  Instead of a simple, easy to follow investing plan that eliminates most behavioral issues by minimizing transactions and decisions in difficult market conditions, you now have one that practically requires a working crystal ball to be successful.

Stop-Loss Programs Introduce Unrealistic Expectations, Creating Behavioral Errors

Imagine you're using the stop-loss program noted above.  What happens if the security drops 78% (like REITs in 2008)?  You're all-in from 25% down to 78% down.  How much did that stop-loss program really save you compared to a buy-and-hold program?  The buy and hold guy lost 78% and had no transaction costs.  The stop-loss guy lost 71% plus any transactional costs (assuming no gapping or whipsawing, which is very unlikely in any type of severe bear market.)  I doubt any investor who was interested in a stop-loss program to minimize his losses is going to be very happy with a 71% loss instead of a 78% loss.  If he was uncomfortable with a 6%-15% loss, he surely isn't going to be willing to pile in more money after the price of the investment has dropped 78%.  In fact, it's unlikely he could have watched it drop from 25% down to 50% down without selling.   The more complex the program, the less likely an investor is to stick with it in those times when it is most critical to do so.

Stop-loss orders, like dollar-cost averaging a lump-sum into the market, seem sophisticated, but in reality are simply a behavioral crutch that doesn't make logical sense.  The solution to decreasing your investment risk isn't to attempt to hold more of a risky asset some of the time, but simply to hold less of a risky asset all of the time with a broadly-diversified, regularly-rebalanced, buy-and-hold portfolio of low-cost, passively-managed funds.

What do you think?  Do you use stop-loss orders?  Why or why not?  Continue the debate in the comments below!