Stop-Loss Orders are a hotly debated topic in Finance. Some people love them, some people hate them. In this article we will delve into what stop-loss orders are, and whether long-term investors should use them.

How do stop-loss orders work?

A stop-loss order is an order type designed to limit losses in a market downturn. A stop-loss order has a stop price at which the security will be sold. When the security price decreases to the stop price, the security is sold. Imagine the stock of company XYZ trading at $50. You create a stop-loss order with a stop price of $45. As long as the stock price remains above $50, nothing happens. When the stock price decreases to $45, the stock is sold for $45 (this is a simplified explanation).

Loss reduction or missing out on gains?

Stop-loss orders are intended to provide protection from significant downturns in the market. Yet, for long-term investors in broad equity ETFs, triggering a stop-loss can incur substantial losses. The nature of these indexes, tied to the overall performance of the market, means that short-term fluctuations are inevitable. Selling based on these fluctuations risks locking in losses that may ultimately be recouped over the long term. As a big believer in long-term investing via ETFs, I don’t mind some short-term fluctuations. I would rather have all the short-term fluctuations and not miss out on any of the long-term gains than the other way around. As such, for long-term investors, the potential loss incurred from triggering a stop-loss likely outweighs the benefits.

Can you time the market or not?

Employing stop-loss orders inherently implies a belief in market timing. It implies that, when your stop-loss order is triggered, you avoid further losses to your position. A belief in market timing is a key assumption of active investing. As such, a belief in market timing clashes with a passive investment strategy, which assumes that markets are efficient and that market timing does not produce positive returns.

Most long-term investors are well aware of the futility of trying to predict short-term market movements, as we have discussed in this article. Attempting to time the market through the use of stop-loss orders can lead to missing out on a rising market, ultimately leading to lower returns. Research and empirical evidence consistently demonstrate that individual investors tend to underperform market benchmarks when attempting to time their entries and exits.

Conclusion

In conclusion, for long-term investors, stop-loss orders are most likely not worth it. The potential losses incurred from triggering stop-losses outweigh the perceived benefits. Instead, investors are better served by maximizing their time in the market while ignoring market timing. In doing so, they will reap the rewards of patient, disciplined wealth accumulation.