Can stop loss orders save me from the next bear market?

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Jeffrey A. Harrell, CFA | Director of Portfolio Management

After every major stock market decline a handful of investors will start asking themselves why they didn’t sell after the market dropped around 10%? The logic appears so simple after the stock market drops 20% or more, right? Investors can now see with perfect hindsight that the first 10% was only the beginning and they should have known more was to come. They begin to speculate that in the future a plan as simple as this will eliminate large losses. Unfortunately, reality creates a much different outcome than what this seemingly foolproof approach will accomplish.

The first problem with this strategy is a lack of understanding normal market volatility. We all know the stock market has trended up relentlessly over long periods of time. Despite this upward trajectory, on numerous occasions stocks have suffered widespread losses. While most are measured in weeks or months, some have lasted years. Full recognition of this as part of the risk an investor must take to seek equity type returns is paramount to successful long-term investing.

With that in mind, would it surprise you to find out that the S&P 500 Index has averaged a 10% decline once every 16 months since its inception? As for a 20% decline…once every 7 years. Simply extrapolating this data out indicates for every 10% decline in the stock market, only 1 out of 5 of these have ended up declining 20% or more. This implies a success rate of only 20%, suggesting you are more likely to sell using this strategy when what really has occurred is a buying opportunity.

A great example of this was a former client of ours who informed us he was never going to watch his portfolio drop the way it did during the 2008-09 bear market. He decided he was going to go to cash the next time the S&P 500 dropped 10%. Remember, it is only with perfect hindsight that we know the stock market bottomed in 2009 and began the longest bull market in history. In the early years of the recovery investors were highly skeptical of rallies with many fearing the new bull market would be short lived. Well…it did not take long for him to put this plan into action as stocks dropped 10% within a year of him making this decision. As he said he would, he executed his plan by dramatically reducing his exposure to the stock market.

It only took a couple of months for stocks to recover after his dramatic portfolio adjustment. Unfortunately, he was unable to accept that he had made a bad decision and kept his portfolio ultra conservative for almost two years…waiting for a pullback. The pullback never happened as stocks marched higher and higher. At some point the S&P 500 rallied more than he could handle. He finally cried mercy and began investing again. This emotional decision cost him years of annual spending in retirement.

The next problem we see with this approach is even if you manage to get it right and go to cash before things get much worse it begs the obvious next question. When do you get back in? Emotions always run hot when stocks have dropped sharply. It is natural to second guess yourself and think about what you would have or could have done. Unfortunately, all these thoughts do is exacerbate the problem.

We had another client go to cash in October of 2008 after the market had declined more than 20% since it appeared there was no end in sight to how low the stock market could go. In this case, he was proven correct over the next six months as the stock market ultimately dropped around 50% from its 2007 peak. Obviously, he was very happy with his decision at that time, but we warned him that stocks could begin moving higher without warning. He said he totally understood and would definitely get back in, but for now he was comfortable in cash. He stayed in cash for nearly four years, missing out on more than a 100% return from the S&P 500 over that time. Again, years of retirement spending foregone due to an emotional decision.

Based on our experience, clients who have tried to use a stop loss strategy to reduce portfolio losses, have more often than not, actually exacerbated them. Stop loss orders force you to become a market timer, which all historical evidence suggests is a really bad idea. Accordingly, we strongly advise against the use of stop loss orders as a means of portfolio insurance for long-term investors.

 

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The statements and opinions expressed herein are subject to change without notice based on market and other conditions.  The information provided is for informational purposes only and should not be construed as investment or legal opinion.  Please consult a tax or financial advisor with questions about your specific situation.  Investors may not invest directly in an unmanaged index.  Past performance is not a guarantee of future returns.