Tuesday, September 13, 2011

Value Investors and Stops

Stop-loss orders are often recommended to investors of all types, especially when the market is as volatile as it has been lately. For value investors, however, the benefits of stop-loss orders are not as high as they are for other market players
, yet value investors still fully suffer from the drawbacks of stop-loss orders. The question therefore becomes: should value investors use stop-loss orders?

On the one hand, stop-loss orders can still serve a purpose. For example, if bad news for a company gets released during market hours and the stock goes into free-fall, a stop-loss could get an investor, still unaware of the news, out of the stock just minutes later.

On the other hand, value investors tend to understand what they are buying (lowering the risk of an unexpected impairment), prefer companies with low debt to capital levels (lowering the risk that a company will have some sort of negative credit event), and prefer to take advantage of volatility (rather than fall victim to momentum trading). As such, they are less likely to benefit from the protections offered by a stop-loss.

So while the benefits to stop-loss orders may not be as large for value investors, they still suffer from the negative effects of stop losses: when the market panics unjustifiably, stop loss orders kick in and investors are exited from their positions at prices far inferior to what they may have been willing to sell for!

Consider what happened just a couple of years ago to the parent company of United Airlines (NASDAQ: UAUA). Panic swept the market after a false rumour of bankruptcy spread throughout, causing the stock to drop 99.92% (from $12 to one penny!). Following news that the rumour was false, the stock returned near its original level. Those with stop-losses got exited at terrible prices, as the stock dropped like a rock. Even if an investor had a stop loss at $10, it would have been filled at a much lower price, since there were no buyers at $10 during this panic.

While we've previously discussed the idea that airlines do not make for very good value investments, the example depicted above can happen to any company when a market panic occurs, even if there has been no change in a company's fundamentals.

Before deciding whether or not to use stop-losses, value investors should ensure they understand both the (possibly reduced) benefits as well as the drawbacks.


Anonymous said...

Do you use "mental stops"? When an investments goes against you (never mind the reason), do you have a preset risk limit (like max loss of 10%)?

Saj Karsan said...

Hi Anon,

Unless the company's value has changed, I'm more more likely to buy more (rather than sell) if the price moves down.