Investors hoping for gains through investments in the stock market must naturally bear the risk that the value of their holdings will fall. Prudent investors seek to construct and manage their portfolios in such a way that they bear only as much risk as is necessary to position them to benefit from potential market gains.
Modern Portfolio Theory (MPT), the basis of my investment approach, teaches us that the two best means of controlling market risk while seeking investment returns are asset allocation and diversification. Asset allocation controls the portfolio’s overall degree of market exposure, while diversification reduces the risks from idiosyncratic movements of individual stocks. A diversified portfolio still bears market risk, which investors cannot escape without sacrificing the opportunity for gains. MPT holds that because diversification cannot eliminate market risk, the market prices stocks to compensate investors for bearing that risk. Since investors can essentially avoid stock-specific risk through diversification, the market does not, according to Modern Portfolio Theory, reward investors for bearing stock-specific risk. The more diversified the portfolio, the greater the degree to which the excess risk due to company-specific components of stock price movements fades as they average out, leaving only the influence of the overall movement of the market. The market risk of a fully-diversified portfolio is the minimum risk an investor in the stock market must bear and still have the opportunity to benefit from potential market gains.
Long market experience shows that, when evaluated over the long term, investing in the stock market through a diversified portfolio is a superior strategy, even with the market’s ups and downs. Nevertheless, there are periods when the market declines —gradually or suddenly — and so many market investors look for ways they can both participate in the market’s upside and avoid market downturns. No strategy can reliably permit investors to capture 100% of the market’s upside while avoiding a meaningful part of its downside. Nevertheless, investors still frequently seek methods by which they can minimize the impact of major downturns to their portfolio.
One strategy that seems to offer protection to investors who are worried about major market downturns is the use of stop-loss orders. A stop-loss is a pre-set order to sell a stock in the event that its market price falls to a given level. Such orders generally stay in effect for a specific period of time, typically not longer than six months—which is the limit allowed for stop-loss orders at both Fidelity and Schwab. Investors might naively imagine that stop-loss orders preserve all of their upside, while limiting their downside. But using stop-loss orders neither preserves upside gains nor prevents down losses the way one might expect. If a stock touches its stop-loss price and then recovers, the stop-loss will cause the investor to miss the recovery, locking in the loss instead. Below I outline a number of the significant problems associated with endeavoring to manage risk in a diversified portfolio using stop-loss orders.
A stop-loss order could potentially make sense for a particular stock position that is concentrated enough within a portfolio that an idiosyncratic move in that particular stock could have an out-sized effect on that portfolio. Even in such a case, simply selling much of the large position (preferably at a relatively high price) and using the proceeds to diversify the portfolio would generally place the investor in a superior risk-reward posture. But, in certain cases, investors have reasons for holding onto concentrated positions and opt to use stop-loss orders for pure defensive reasons.
The question then arises as to whether or not an investor can apply a large number of stop-loss orders within a well diversified portfolio as a means to protect the portfolio by “cashing out” if the market falls. This would mean placing stop-loss orders on a large number of positions. But what sounds like a simple plan turns out to be rather complicated. In ordinary markets, the stop-loss orders will be most likely to cause the investor to sell the most volatile positions, those most likely to fall sharply and then recover, at their low points. In a general market downdraft, one severe enough to trigger a large fraction of the stop-loss orders on portfolio positions, the pre-set stop-loss orders become a rather inflexible, blunt and indiscriminate weapon that automatically takes the investor out of the market at a low point—typically for a loss or reduced gain. At that point the investor’s challenge is then to decide when is the right point to get back in so as to avoid missing a possible subsequent recovery.
Within the context of a well-diversified stock portfolio that is part of a sound asset allocation strategy, stop-loss orders amount to redundant layer of risk-control, which reduces opportunity more than it reduces risk. To use such an approach successfully, an investor would have to make multiple choices correctly, something that is virtually impossible in a volatile market. What should be the stop-loss price? If the stops are too “tight” — too close to current levels — a small, temporary wobble could trigger them. If the stops are well below the current price, they only come into play after a steeper market drop, locking in a correspondingly greater loss.
Most people don’t seek to sell their securities at the low, yet a stop-loss order risks triggering sales near the bottom of normal fluctuations in individual stocks’ prices. Depending upon the level of the stop loss orders, investors may find themselves “stopped out” of positions — and possibly forced to recognize taxable gains — at the wrong time in the market. A market downdraft such as the one we experienced in the first quarter of 2020 must have triggered stop-loss orders on a large number of stocks at a number of different points. The need to fill those orders may, in fact, have contributed to the violence of the market’s fall on the worst days in March 2020. Investors whose stocks reached their stop-loss prices may have experienced relief when they sold their stocks, but in that event, unless they bought back in immediately, they would have been out of the market when it rebounded, missing the opportunity to recoup their losses.
From my perspective, investors are more likely to fall short of their investment goals by being out of the market when it is going up, than by being in the market when it is going down. There are always ups and downs. Stop-loss orders greatly increase the chance of selling at or near the bottom of the market — whenever that happens. If the strategy consists of placing a stop-loss order without a plan as to what to do after a stop-loss sale, the effect is to lock in losses.
The next issue is this: If a market downdraft triggers a large number of stop-loss orders on an investor’s positions, what should the investor do next?
One choice is to buy back into the market immediately. That would be in keeping with a typical asset allocation strategy, but that would appear to defeat the purpose of the stop-loss orders. An investor in a diversified portfolio would not be replacing a losing stock that did not work out, but much of the portfolio. The investor could try to wait for some propitious opportunity to buy back in, but how can anyone determine when that would be? The final choice is simply to stay in cash (at basically zero yield in recent months) for an indeterminate period, missing whatever gains (or losses) the market offers in the future. An investor choosing this course after being stopped out of most positions in the market downdraft in March 2020 would have missed the startling market rebound that began in the last week of that month.
Stop-loss orders also have technical problems. They’re clumsy to manage, and they don’t necessarily work the way a naïve investor might expect. A stop-loss order doesn’t guarantee the investor the stop-loss price. If the stock’s market price reaches the investor’s stop-loss price, that order becomes a market order, and it goes into the queue for execution at market. This can be a problem in thin markets, or if there’s a “gap lower” — a discontinuous jump downward in the market price.
On several days in March 2020 the US stock market opened far enough below the previous night’s close to trigger a market “circuit breaker.” On those days the S&P 500 basically opened 7% below the previous close, leading to a 15-minute trading halt. On each of those days, when trading re-opened, the market traded somewhat lower still. Investors with stop-loss orders just below closing prices of the night before one of those circuit-breaker days might have found they had sold their shares 8-10%, or more, below their stop-loss prices. It is impossible to state the prices at which the resulting sales would have occurred in those volatile, chaotic days in March. Many investors undoubtedly found they they had sold positions well below their stop-loss prices.
The worst possible market for stop-loss orders is exactly the type of market we have just experienced. The volatile, sawtooth market decline must have trigger sales at prices well below the hoped-for stop-loss levels for many investors. Investors with 20% and even 30% stops on their portfolio would have found that they triggered the sale of nearly all of their stocks in early March 2020. Then, any delay in reinvesting the proceeds would have missed a significant portion of the subsequent recovery that happened unpredictably at the end of March.
Stop-loss orders are a seductive idea, because they seem to offer a strategy that captures all gains and avoids losses beyond a certain level. But that doesn’t really work for a diversified, long-term portfolio. Investors with a long horizon must accept the inevitable fluctuations in the market, or face the near certainty of falling short of their investment goals. Placing stop-loss orders on a large portion of their holdings would create a high probability that, some unpredictable time in the future, the orders would trigger the sale of much of the portfolio at depressed prices, causing the portfolio to revert to cash at what could be the worst possible moment.