Category: Personal Finance
On May 6, the Dow Jones Industrial Average experienced the largest one-day point decline on an intraday basis in history when it went down by 998.5 points. This “Flash Crash” was followed by an immediate recovery. The cause is still being investigated, but it does raise concern about the stability of our markets and whether trading strategies that were effective in the past are still appropriate for the future.
The uncertainty and unpredictability of the markets is frustrating for even the most rational of investors. Given that the pain of the last bear market is still fresh, strategies aimed at limiting downside risk are particularly enticing. Unfortunately, these strategies can backfire. While not new, one such strategy that has gained recent popularity is the “stop loss” order.
What is a “Stop Loss” Order?
The concept is very simple. An investor places a standing order to sell a stock if the price drops below a certain level. The goal is to limit the loss to a value acceptable to you. For example, let’s assume that you own a stock valued at $50 a share. You like the stock and consider it a good investment. However, you want to protect your downside. You enter a “stop loss” order that automatically sells the stock if the price goes down to $45 (a 10% loss). With this “stop loss” order in place, if the value drops to $47, nothing happens. If the value drops to $45, your stock will be sold. However, the $45 sale price is not a guarantee. If the stock price drops quickly, as it did on May 6, the automatic sale will occur, but potentially at a price well below your target of $45.
In 2008, the “stop loss” strategy would have worked well assuming the investor knew when to get back into the market. For investors who hold a large amount of their wealth in a single stock, it can be a good way to passively protect from a “worst case” scenario. However, many times this strategy will lead to poor returns over the long-run. This is because stocks, which by their nature tend to be volatile, may drop for a short period of time (triggering a sale at a lower price) and then move right back up. The result is the exact opposite of “buying low and selling high”. You end up selling at a low price and missing out on the up-swing.
On Thursday, May 6, 2010, the “stop loss” strategy would have been particularly damaging. That afternoon, the Dow Jones Industrial Average experienced a quick decline and then rapidly dropped nearly 600 points in five minutes of trading. At the low of the day, the index had dropped more than nine percent from the prior day’s close. Then, nearly as quickly as it had happened, the index shot right back up. Some trades that occurred within that period of time have been declared invalid. However, for the investors whose “stop loss” sales will not be declared invalid, the market disruption caused a real loss.
At this time, the SEC has not determined the cause of the May 6th activity. Whether sparked by a trading error or legitimate selling, the recent downturn might bring back some bad feelings. It is important to note that, unlike the volatility in 2008 and early 2009, the US financial system is approaching stability and we are heading out of a recession in a strong way. Even with the more than 65 percent increase in the S&P 500 index from the March 9, 2009 low, stocks have plenty of additional upside potential over the next few years.
As a savvy investor, you look for strategies, like the “stop loss” order, to protect your profits and maximize the returns of your portfolio. However, as with many investing strategies, there is no guarantee you will get the results that you expect.
This article was contributed by Charlotte Lippert, CFA, an investment manager at Bedel Financial Consulting, Inc.
Elaine E. Bedel, CFP®, is president of Bedel Financial Consulting, Inc., a wealth management firm providing fee-only financial planning and investment management services for individuals, consulting services for corporate retirement plans, and investment advisory for institutions and endowments. She is the author of “Advice You Never Asked For…But wished you had!” available on Amazon.com. For more information, visit their website at www.BedelFinancial.com or email to email@example.com.
© 2010 Copyright Bedel Financial Consulting, Inc. All rights reserved.
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