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Three important rules to remember when using stop-loss orders

John Reese is CEO of Validea.com and Validea Capital, and portfolio manager for the National Bank Consensus funds. Globe Investor has a distribution agreement with Validea.ca, a premium Canadian stock screen service. Try it.

'Stop-loss." For investors, the term has a comforting ring to it. Who wouldn't want to put a cap on the amount you could lose on one of your holdings?

In reality, however, stop-loss orders (which require a stock to be automatically sold if and when it hits a predetermined loss) are a double-edged sword. If not used properly, they can wreak havoc on your portfolio – particularly if you are a value investor.

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Value investing involves buying stocks that are trading at low prices when compared with fundamentals such as earnings, sales and book value. It works over the long haul because investors are emotional creatures. Many overreact to short-term problems and fears and sell stocks of companies that are solid long-term bets. That creates bargains that disciplined long-term value investors pounce on, reaping the benefits when fears subside and the shares rebound, as is often the case.

The great challenge is that cheap stocks can get cheaper in the short term. The fact that a good stock is a bargain at $20 a share doesn't mean that it won't fall to $15 or $10 before it rebounds, as more and more fearful investors bail. Because people's emotions are in play, not even the smartest investors are able to reliably predict when a stock will bottom. If you buy that $20 stock and set a 40-per-cent stop-loss, you could "stop out" of the holding when it falls to $12 – only to watch it rebound ferociously weeks or months later.

The other thing to realize is that stocks, generally, have a lot of variability in their returns. For instance, small cap stocks, as defined by stocks below $2-billion in market capitalization, have an annual standard deviation of 23.2 per cent from 1972-2013 (and that figure jumps significantly if you go back to the mid-1920s) according to 2014 Ibbotson SBBI Classic Yearbook. So this means that if small cap stocks have returned 11 per cent to 12 per cent annually over the long term, the performance around that average return can vary by 20 per cent to 30 per cent the majority of the time. Running too-tight stops could wreak havoc on an investor's portfolio as the normal volatility could easily result in getting stopped out and a "whipsawing" effect.

With all that being said, stop-losses are a good tool if used properly and I use them in most of the money management strategies I run. I think there are three important rules to keep in mind if you are going to employ them.

1. Be dynamic
Rather than using a fixed stop-loss target, I believe in using a dynamic target that assesses how a stock performs compared with the broader market while in your portfolio. A dynamic stop-loss is one that is adjusted based on how the market performs from the time you've purchased the shares you own. For example, you could set a stop of 30 per cent or 40 per cent and add or subtract to the stop threshold based on the percentage increase or decrease of the market over the same holding period. Using a dynamic stop-loss target has some key advantages over a static target. For example, it prevents a situation in which a major market decline forces you to sell off all of your best ideas because of short-term market conditions. Think about late 2008 and early 2009. If you were using a static stop-loss target of, say, 30 per cent or even 40 per cent, you might have ended up selling most of your portfolio, which represented your best ideas, and replacing them with less-attractive stocks that likely had tumbled just as significantly.

2. Don't go too low
As I noted above, stocks move up and down significantly in the short term based on factors that have little to do with a company's underlying prospects. If you use a stop-loss target that is very low, you will find yourself selling many of your holdings even if their long-term prospects remain quite strong. A stop-loss should be used to help identify significant losers that have significant momentum going against them. If you are a long-term investor and are using a 5-per-cent or 10-per-cent stop-loss, you might want to reconsider whether you should be investing in stocks in the first place.

3. Stick to it
Discipline is key when it comes to implementing a stop-loss strategy. If you set a stop-loss target of 30 per cent, for example, you should hold all of the stocks you buy to that standard. If you start picking and choosing when to employ the rule, you are likely to start making emotional decisions. And, in the vast majority of cases, making investment decisions based on emotion leads to big trouble.

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If you do use stop-losses keep an eye on your stop-loss strategy's results. Monitor how the stocks you stop out of fare after you sell them. If you notice that many of them rebound strongly, you should think about adjusting your stop-loss target.

And, if you find that you are stopping out of a good number of your holdings, you should step back and look at the bigger picture. If your stock-picking strategy is leading you to a number of stocks that are hitting a 30-per-cent or 40-per-cent stop-loss threshold, you should think about using another approach to choose equities.

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About the Author

John Reese is CEO of Validea.com and Validea Capital, the manager of an actively managed ETF. Globe Investor has a distribution agreement with Validea.ca, a premium Canadian stock screen service. More

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