Popular But Problematic
Many popular tactical myths are problematic and costly, yet continue in their popularity because they appeal to our blindsided brains—they feel so right—and we typically don’t know how to think them through. Sometimes these tactics (like stop losses and dollar-cost averaging) were promoted by the brokerage industry decades ago because they increased trading and hence transaction fees. Questions One and Three help you here because you can measure whether they work and see why your brain finds them appealing.
Stop Losses? More Like Stop Gains
The concept of a stop loss—even the name—is so appealing it’s easy to see why this maneuver is popular. A stop loss implies setting some arbitrary percent (or dollar) amount of decline. When a stock hits that level, you sell and buy something else. For example, if you always stop losses at 15%, you will never have a stock that is down more than 15%. No disasters. No Enrons. Sounds good. If not 15%, you can pick any other arbitrary amount, like 10%, 20%, 12.725%. Whatever! This is a control mechanism.
But stop losses don’t do what investors want them to do. On average, they lose money, they don’t make money. They feel good but are bad. Why? Because stocks aren’t serially correlated—meaning when a stock moves in any given direction, the odds are 50/50 that it continues in that direction or reverses trend. There is a huge body of scholarly research based on real data proving historical price movement, by itself, ...