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Stop-Loss Is a Cure for Emotional Investing

May 14, 2015

Twice in the last 15 years — in 2002 and 2008 — the market has lost 20% to 30% after a long run-up. Clients who are nervous in today’s investment environment likely experienced those downturns firsthand and don’t want to go through another one. Yet there is a simple tool within every advisor’s reach to calm them down: stop-loss orders.

These automated safeguards can help clients maintain the discipline of their investment strategy. They reassure investors that if the market does take a turn for the worse, they won’t have to ride it to the bottom. Stop-loss can be completely mechanical, using predetermined triggers to sell equities from a portfolio automatically. In most cases, the trigger is a market drop of 10% from the previous annual high. It is also easy to structure orders for buying back into the market at a predetermined level — without emotion.

Overall, advisors should find that convincing clients to employ stop-loss orders is relatively straightforward: It’s usually sufficient to illustrate how limiting losses in the most severe markets can make a huge difference in their long-term plans. It also helps to remind them that a 20% drop requires a 25% return to break even, a 30% drop requires a 43% increase, and a 40% loss is recovered only after a 67% gain. Even confident investors tend to find that reassuring, as no one can argue with a backup plan.

For most investors, stop-loss is a safety net that helps keep them on track toward meeting their long-term financial objectives. This is particularly important for clients approaching retirement. Given the impact the crash of 2008 made on retirement savings, a stop-loss is critical for investors who will soon need to start taking withdrawals from their investment accounts.

On the other hand, the strategy is not for everyone. The risk that a stop-loss will force them to miss some of the gains that immediately follow a steep market drop may loom larger to some investors than the risk of market loss. The same is true for do-it-yourself investors who manage their portfolios on a day-to-day basis. On the other end of the risk tolerance spectrum, even a 10% loss may be too great for the most conservative clients — so traditional income and interest sources, such as bonds or CDs, may be more appropriate for them.

Stop-loss is clearly designed to limit downside risk. Losses are more powerful than gains, after all, and most baby-boomer investors don’t have time to recover from a market correction or crash. For them, stop-loss orders can greatly reduce the anxiety of being in the market. However, gains are the goal of the investing game — and with a stop-loss safety net in place, clients of all types can invest more confidently.