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Club Use of Stop-Loss Orders
Dear Doug:
What is your advice on the use of sell-stop orders if the club decides they
have a loss risk tolerance of, say, 25%? We have discussed risk tolerance
in our club but have no mechanism in place for acting on our expressed
tolerance level. Currently, if a stock falls in price between meetings to
the tolerance level, we are unable to pull together a vote to sell the
stock. Is it a good idea to use sell-stop orders if you set the sell-stop
low enough to allow for quite a bit of market volatility?
- Joanne
Dear Joanne:
I'm not a big fan of using stop orders in an investment club. For those
unfamiliar with the term, a sell-stop order (also known as a stop-loss
order) instructs your brokerage firm to sell the shares of a stock you hold
in your account if its price falls to a designated level you set. Stop-loss
orders are intended to be a risk management tool, to protect you from a
stock that falls in price—in other words, to stop a loss in your account.
I wonder, how did you decide on setting stop-loss prices at 25% below the
most recent price of the stock? By the time a stock has fallen 25%, most of
the damage will usually have already been inflicted on your portfolio. What
's the chance that the stock could decline more than that between your club
meetings? If your club is speculating in stocks, rather than investing in
quality companies with a careful and thoughtful strategy, then I think your
club may be missing the point of club investing. Investing strategies that
require constant vigilance and the use of stop orders may work for
individuals with lots of time on their hands, but not for clubs.
Another problem with stop-loss orders is that they create a transaction in
your portfolio with no intervention on the part of your club. I'm a firm
believer that clubs should have a "sell discipline" in place, just as they
have a strategy for buying stocks. Whenever you sell a security, there are
tax ramifications. Are you incurring a gain or a loss, and is it short-term
or long-term? What are the tax consequences of that transaction, and will
you now be looking to execute an additional transaction to offset a gain?
The larger problem with stop-loss orders is that you may be taking an action
precisely opposite that suggested by the price decline. If you have built a
portfolio of carefully selected, high-quality, long-term growth stocks, a
short-term drop of 10%, 20%, or even 30% may be painful, but it may not
necessarily mean that the stock no longer belongs in your portfolio. In
fact, if you have a long-term perspective, the price decline may even
represent a great chance to buy more shares at the depressed price. But if
the shares have already been sold at a loss, you'll have to wait 30 days so
you don't incur the wrath of the wash sale rule. That probably means you'd
have to wait another meeting or two before re-evaluating the stock, and who
knows whether the price will have rebounded by then?
I once came across a club that faithfully set stop-loss orders on all the
stocks in their portfolio. In between meetings one month, a bit of market
turbulence knocked most of the club's portfolio down to its stop prices, so
most of the club's portfolio was sold off as the stop-loss orders were
executed. By the next meeting, however, most of the stocks had recovered
and were actually a bit higher than at the club's previous meeting. But the
club had nothing to show for their careful use of stop-loss orders except a
whole lot of capital gains and losses—and a lot of cash in their account.
There's a reason that some people refer to stop-loss orders as "broker
enrichment orders": investors end up paying commissions, often needlessly.
My prescription for your club is a dose of patience. If a stock drops
between meetings, your club should wait until its next meeting and then
review the reasons for the decline. Only then should they make a decision
to sell—or to hold, or to buy more shares.
- Doug
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