Pros and cons of using stop-losses

Here are two episodes to illustrate the pros and cons of using stop-losses:

Cons

"So, in December 2003, I invested in the company at an effective price of 90 cents, which implied a market capitalisation of about $220 million. Over the next six months the price had a strong trend - downwards. In July 2004, it fell to as low as 55 cents.

This was around the stop-loss level I had in mind when I invested.

There didn't seem to be any reason for the dramatic fall. Everything seemed to be going on track for the company. The network was being set up, trials of the system were progressing and the modems they had ordered were being delivered.

Here was a classic stop-loss dilemma. If I had thought that there was any way the price would drop so severely, I would not have invested. The fundamentals were sound, so if anything the company was a buy at this price, rather than a sell.

I held on to my investment. Since I had quite a large position, I didn't buy any more. Fortunately for me, the price recovered as the company achieved some success with its product launch in August 2004 following a strong advertising push. That sent the price to over $1.10. I later exited my position at around $1.00, when I became worried about potential competition emerging from other companies."

Pros

"I had a tough experience with my ARC shares, where cutting a deteriorating position would have been the better choice than hanging on, and where clearly I was stressed and lacked discipline - exactly the problems that a predetermined stop-loss strategy seeks to avoid. "


---

In the first episode, the investor did not use a stop-loss, and the market recovered allowing him to salvage a small percentage profit. His confidence was rewarded.




Summary on stop-loses

Have a stop-loss in your mind when you invest and if the price hits the stop-loss level, always cut if:

• the loss is threatening to be destructive;
• you are confused about what is going on; or
• the fundamentals are moving against you.

You should only keep the position and consider increasing it if you remain genuinely confident about the underlying fundamentals. Experience will help you recognise when you are starting to rely on nothing but hope. If you do stay in, choose another stop-loss level as a reference point, and stay disciplined.

You should also manage risk by not betting too much on one idea and by anticipating market moves twice as big as seem reasonable.