Stop losses are widely used by many private investors, but one Fool thinks they can do more harm than good.
I'm a fairly sad individual and I spend far too much time reading investment discussion boards, both here at The Fool and on other sites too.
I often read messages where investors say they've set a "stop loss" in ABC plc at so and so a price, and I get irritated every time I see such a message. That's because I believe that stop losses make it much harder for a private investor to beat the market.
For the uninitiated, a stop loss is an order to your broker to automatically sell a share if its price drops to a certain level. The idea is that a stop loss policy will protect your portfolio from massive losers.
Imagine you bought some shares today in Tesco
(LSE: TSCO)
at 369p. You don't want to suffer a big loss, so you instruct your broker to sell your shares if they fall 10% to 332p or below. Alternatively, you could monitor the share price every day, and hit the sell button yourself if there's a 10% fall.
Sounds reasonable, doesn't it? But once you've sold one share at a 10% loss, what do you do then? Probably buy a second share, and that second share could go and fall 10% too. Sell that one, and your capital is beginning to get eaten up. What's more, it's possible that your first purchase could outperform the second share over the long-term. You might have been better off to stick with your first pick.
Remember, shares can be volatile. They normally don't move up in a straight line. Look at Tesco's
(LSE: TSCO)
share price chart for the last year. Had you bought Tesco shares on September 6, 2005 at 333.5p, you would now be sitting on a 13% return including dividends. Yet had you followed a stop loss policy, you would have sold the shares on 27 October when the share price had fallen to 295p.
For me, it makes much more sense to buy shares in attractively valued, well-managed companies and hold them for years. Sure, if your share falls by a significant amount, there's no harm in checking to make sure that your initial buy case still applies. If the circumstances surrounding the company have changed dramatically, then you may want to consider a sale.
But more often than not, the circumstances won't have changed dramatically. The share price may just have been hit by a change in short-term sentiment. Perhaps the market as a whole has fallen. Or maybe Sainsbury
(LSE: SBRY)
has had a good quarter and investors have wrongly assumed that Tesco must be suffering as a result. If circumstances haven't changed, the best approach is to hold for the long-term.
And if you're looking for investments to hold for years, not months, why not take a 30-day free trial to our share-tipping newsletter, Champion Shares? We've recommended 15 shares since the service launched a year ago, and we haven't advised readers to sell a single one so far!
But whatever you do, don't listen to the siren calls of bulletin board posters and tipsters who claim that stop losses reduce risk. The way to reduce risk is to buy decent shares in the first place.
Thanks to Jim Mueller for the concept for this article.
