Just stop it with the stop-loss orders

I went to cash just before the pandemic (good) but then stayed out during the market’s big climb (bad). I started buying again last fall and am now two-thirds fully invested in high-quality dividend stocks. Here’s my question: When I buy a stock, should I be paying more attention to the stop-loss function? If so, what guidelines do you suggest?

That’s the thing about selling when stuff hits the fan: You might spare yourself some losses on the way down, but it takes an iron stomach to get back in. Most people wait until they see clear signs that the crisis is ending, by which time prices have already recovered. I probably don’t need to remind – but I will anyway – that holding great companies through good times and bad is a tried-and-true recipe for investing success.

Which brings us to your question about stop-loss orders. When you place a stop-loss order, you are instructing your broker to sell the stock when the market price drops to a certain level. Unless you specify otherwise, the stop-loss order then converts to a market order, meaning the broker will sell the shares at the best available price.

I can think of plenty of situations in which a stop-loss order might have come in handy. Shopify Inc. (SHOP), which has plunged about 80 per cent over the past seven months, jumps to mind. So do Netflix Inc. (NFLX), Canopy Growth Corp. (WEED) and Coinbase Global Inc. (COIN), all of which have been spectacular busts.

Apart from getting crushed, these stocks have something else in common: They are all highly speculative, and they don’t pay any dividends. What’s more, their prices tend to be very volatile. So, if you invest in these sorts of higher-risk stocks (which I don’t recommend, unless you hold them through a diversified exchange-traded fund) stop-loss orders might be worth considering.

However, you said you’ve been buying “high-quality dividend stocks,” by which I assume you mean things such as banks, utilities, telecoms, power producers and real estate investment trusts. I hold these kinds of stocks personally and in my model Yield Hog Dividend Growth Portfolio, and I can tell you I have never used stop-loss orders with them.

Why not? Because a stop-loss order is antithetical to the buy-and-hold philosophy. If you own conservative, reasonably valued companies with rising revenues, earnings and dividends, the only thing a stop-loss order will accomplish is dumping your stocks overboard at the worst possible time.

Allow me to illustrate using some actual historical numbers.

Say you bought 500 shares of Royal Bank of Canada (RY) when they were trading at $100 in the late summer of 2019. Maybe you thought to yourself at the time, “I’m going to play it safe and enter a stop-loss order at $80 because I want to protect myself if something bad happens.”

Sure enough, six months later, a once-in-a-century global pandemic arrives and the market tanks. Whew! Good thing you had the foresight to enter that stop-loss order, right?

Wrong. On March 12, 2020 – the day after the World Health Organization declared the COVID-19 pandemic – Royal Bank’s shares plunged more than 10 per cent to $78.61, down from the previous close of $87.87. Because the price dropped below your $80 stop-loss threshold during the day, your broker would have automatically sold your shares.

But guess what happened next? Royal Bank’s stock shot up nearly 15 per cent the following day. You would have watched the rebound from the sidelines, possibly with tears in your eyes, because all you would have accomplished is selling a great stock at a lousy price.

If you are a long-term investor in great businesses, as opposed to someone who gambles on speculative stocks, stop-loss orders aren’t your friend.

In his book, Debunkerybillionaire US money manager Ken Fisher says small investors should steer clear of stop-loss orders – just as most institutional investors do – because they drive up trading commissions, trigger taxes and don’t accomplish what people think they do.

“It would be more accurate to call them ‘stop-gains,’ ” Mr. Fisher says. “They’re just pricey security blankies for nervous investors. Except blankies don’t do any real harm, while stop-losses are pernicious little suckers.”

So, instead of trying to stop paper losses, you should learn to accept them as a perfectly normal, and unavoidable, part of investing. Your portfolio will thank you in the long run.

Email your questions to jheinzl@globeandmail.com. I’m not able to respond personally to e-mails but I choose certain questions to answer in my column.

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