Last Updated May 11, 2010 6:00 PM EDT
The argument goes that, without such an order, an investor has unlimited loss potential. Say an investor buys a stock market ETF and puts a stop loss order at ten percent below the purchase price. He then has unlimited upside potential but has limited his losses to ten percent of his investment.
Though this may sound like investing with insurance, it actually has three very large flaws:
Flaw #1 - You will sell low. Investing is about buying low and selling high. When the stop loss order gets exercised, it is because the security has declined. You are guaranteed to dump it after it has gone down. Many claim that this isn't the case because they have the value anchored in their mind at a lower price, such as their purchase price. This is only a mind game, however, since the security could be sold outright at the higher price, rather than the price of the stop loss order.
Flaw #2 - Volatility makes things worse. In the day of computer programs driving the stock market, stop loss orders are especially dangerous. Take the recent week of May 3 - 7 and the stock Accenture (ACN). It wasn't a great week for Accenture. Its stock price fell from $44.19 to $40.32, but according to news reports, Accenture's low for the week was one penny. You may also remember the wild ride of May 6, when the Dow dropped 1,000 points from computer trading, before recovering most of that loss. Thus, if you placed any stop loss, it was executed during the plunge even though prices recovered minutes later.
Flaw #3 - It's not investing. I wish I had a dime for every study that showed timing the market doesn't work. All stop loss investing does is try to time the market. It will get you in and out of stock positions at the speed of light. And many studies show that the more you move in and out of the market, the lower your returns are likely to be.
Stop loss orders are emotionally appealing and, when it comes to investing, most things that appeal to our emotions don't work. I'm a believer in trying a little risk management with the part of your portfolio that's in boring high quality government-backed fixed income. Then manage the risk of your equity portfolio by diversifying and staying in the market for the long-run.