Reservations About Sell Stops
(TMF Sheard)
LEXINGTON, KY. (July 13, 1998) -- In today's issue of Investor's Business Daily, the paper's founder, William O'Neil begins a 26-part series (one part each Monday) on his overall investment advice. Interestingly, he begins the series with a topic we've analyzed and discussed a time or two in the Workshop -- sell stops.
A sell stop (or stop loss) order is placed with one's broker to automatically sell a stock if it sinks to a certain price. Investors who use them think of them as insurance against big losses. (They don't protect one against a sudden price plunge, however. If the stock crashes while the market's closed, a sell stop won't protect you against the plunge.) The theory is that you determine ahead of time what you're willing to lose and set your sell stop at that point as soon as you buy the stock. Then if you've made a mistake, you sell out relatively quickly and avoid an even bigger loss. The level O'Neil recommends is 7% or 8% below one's purchase price.
In theory, it's a very attractive plan. You cut your losers short and let your winners run. But as many investors in the Workshop have found, it's never quite that cut and dried in practice. For one thing, 7% or 8% is extremely tight for a sell stop. O'Neil would say, "exactly... that's the point." But with many small- and mid-cap stocks, a normal correction over a couple of days (even a single day) can bring on such a correction, and then the stock may immediately turn around and soar to new heights. Such a stop loss level has proven to be an invitation to frequent whipsaws.
In fact, a research study done by a team of readers last summer discovered that sell stops levels even considerably looser than 7% or 8% generate more losses as a result of whipsaws than they generate savings through protecting against bigger losses.
O'Neil's sell stop system is really only appropriate for an extremely active trader who's willing to jump in and out of stocks quickly. It's also tied to O'Neil's theory that one should only hold a few stocks and watch them extremely closely -- the old line about it being okay to put all your eggs in one basket if you take very good care of the basket.
For the vast majority of us (and I include myself in this camp), it's not a practical approach to investing. It takes too much time, the costs and taxes can be much higher because of frequent trading and short-term gains, and it's too concentrated an approach.
I've found that for those of us who don't want to be glued to the newswires twelve hours a day, it's a much saner (yet very effective) method to spread one's investments out over a field of 20 stocks so that you're protected well against a big loss in any one stock. Instead of trying to avoid a 50% loss every once in a while, accept them when they occur, knowing that because the position is only 5% of your portfolio, such a disaster only costs you 2.5% of your portfolio.
That eliminates the need to guess when to sell out of a loser to "cut your losses" and doesn't give up profits to whipsaws when you do sell out quickly only to watch the stock soar again the next day.
There's nothing wrong with O'Neil's insurance method if you're going to adopt all the requirements that go along with such a high-intensity investment strategy. But if active investing isn't your full-time pursuit and you want good results and a comfort level that will allow you to sleep, consider fleshing out your portfolio to 20 stocks and letting that diversity protect you against any single stock's collapse. For those of us who are determined to hold all our stocks at least a year, it's a much easier and more cost-effective approach to live with.
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[Robert Sheard is the author of the The Unemotional Investor (Simon & Schuster, 1998) available now at Amazon.com and your local bookseller.]