Debunkery: Learn It, Do It, and Profit From It—Seeing Through Wall Street's Money-Killing Myths

BUNK 12

STOP-LOSSES STOP LOSSES!

Stop-loss! Even the name sounds great. Who doesn’t want to stop losses? Forever! Sadly, stop-losses don’t guarantee against losses—you can lose money with them, and badly. You can also stop future gains, pay more in transaction fees, trigger taxable events, and otherwise make much less money than you would simply leaving these be. It would be more accurate to call them “stop-gains.” In the long term and on average they’re a provable money loser.

How Do They “Work”?

A stop-loss is some mechanical methodology, like an order placed with a broker, to automatically sell a stock (or bond, exchange-traded fund [ETF], mutual fund, the whole market, whatever) when it falls to a certain dollar amount. You pick any arbitrary amount you like. People usually pick round numbers like “15 percent lower than where I bought it” or 10 percent or 20 percent—no reason; people just like round numbers. They could do 13.46 percent or 17.11 percent but they don’t. When the stock hits that amount, it’s sold. No big 80 percent drops. No disasters.

Sounds great, right? Except stop-losses don’t do what people want them to do. If, on average, they were a major money-winning strategy, every professional money manager would use them. But overwhelmingly they don’t. To my knowledge, there’s no big-name, long-term, super-successful money manager who’s ever made a practice of using them—not even occasionally.

Stop-losses don’t work because stock prices aren’t serially correlated ...