They often lock in your losses just before the share price rebounds.
When I told my editor I was keen to write about stop-losses, he told me to watch my step. Some of our members don't like them, he said. In fact, they really, really don't like them. Expect a pasting in the comment boxes below.
I thanked him for the warning, but I'm not too worried about any backlash. I've been testing out stop-losses recently, despite promising myself I wouldn't dabble in the black arts, and I'm not convinced by them either.
Stop my losses, please!
It was the annual September pessimism that got me thinking about stop-losses. It's a horrible month for investors. My portfolio had revived nicely over the summer, and I didn't want to see it bludgeoned in some fresh global bloodbath, so I decided to get a bit defensive.
Will he never learn?
I should have known better. I had suffered bruising encounters with stop-losses before, while dabbling in spread betting. You can read about my troubles here: You Can't Gamble Your Way Out Of A Stock-Market Crash.
Because I wasn't brave or rich enough to do spread betting properly, I set my stop-losses too conservatively, and time after time they closed my bet after markets briefly flipped against me.
My experience confirmed what I had been warned about stop-losses -- that they are a great way of locking in your losses. They are equally adept at stopping you from making any future profits.
What comes after win-win? That's right
But this time, I thought, it would be different. I decided to place stop-losses on a number of individual company shares, ones that had already made me a 25%-plus profit.
That way, if the September slamdown came, I would have clung onto some of my summer profits.
Interestingly, I couldn't bring myself to set any stop-losses on those shares that haven't made any profits yet. Locking in a 10% loss didn't seem as appealing as locking in a 25% gain.
As always with stop losses, the theory is great, and seems to promise win-win, but the practice is less than perfect.
In late August, I placed a stop-loss on Volvere (LSE: VLE), which was up more than 30% since I bought it, and set the stop-loss to trigger if my return fell to 25%.
For added sophistication, I chose a trailing stop-loss, which rises as the share price does, locking in an ever greater chunk of profit. As I said, win-win.
Yer lost!
With the share price at 255p, I set my stop-loss at 235p. Since I bought at 185p in May, that still guaranteed me a nice profit, which I duly took, about one day later, when the share price dipped.
Brilliant, you might think, except the next day it rebounded to 243p, but I had already exited my position.
And that's the trouble with stop-losses. They quit the market at the first sign of gunfire, which is no way to run a red-blooded portfolio.
Stop-losses or stop-profits?
A couple of days later, the same thing happened with my second trailing stop-loss.
Different stock, same story. The share price dipped, my stop-loss pinged, and the stock reverted to its previous level.
I wasn't too upset. Unlike my spread-betting experience, I was locking in profits rather than losses. And I tried my damnedest to follow Bruce Jackson's advice, and not worry about stocks after I had sold (it's not easy, Bruce).
But it is clearly no way to run a portfolio. The September crash hasn't happened yet and two of my three defensive traps have already been sprung.
Any long-term rewards I may have reaped from these stocks has been squandered in the attempt to avert short-term losses.
Once in a blue moon
There are circumstances when a stop-loss can work in your favour. If these two stocks had fallen through the floor, either because of bad company news or a wider market crash, I might be sounding a bit smug right now.
And I would be infuriatingly smug if they had leapt up first, hiking my trailing stop-loss, then plunged.
But that didn't happen. And in truth, it isn't going to happen that often.
Never again?
I still have one trailing stop-loss in place, on Aveva (LSE: AVV), one of Maynard Paton's tips in The Motley Fool's Champion Shares stock-tipping service. I'm sitting on a profit and so I've upped my trailing stop-loss.
But on the whole, I'm not impressed. Stop-losses can protect you from a wider meltdown, but they really aren't equipped to cope with the day-to-day volatility of stock markets.
Stop-losses appear to promise the world, limiting your downside, while leaving you free to explore any upside. But all too often they do exactly the opposite, locking in your downside, by pinging on just one day's bad trading, and barring you from any potential upside.
I don't completely rule out using them again, but I'm in no hurry to set any more at the moment.
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