As every investor knows, buy low, sell high is the way to generate profits in the securities markets. Nevertheless, a lot of (retail) investors are rather buying high and selling low. But why do these investors act this way? From my point of view these investors are driven by greed and fear. They invest late in a trend or in a security with a high upward momentum as they think this trend or momentum will continue and they want to participate from the exceptional return pattern from the past (greed = fear of missing out/FOMO). Unfortunately, past returns are no guarantee for future returns and so these investors are often hit by market corrections and face (in some cases heavy) losses in their portfolio, since prices on the exchange move much faster down than up.
Unfortunately, a lot of investors act too late in these situations and realize high losses in their portfolios.
As loss prevention or capital preservation is one of the keys to becoming a successful investor, here is a hint to protect a portfolio from exceptional losses.
Stop-loss limits are a cost-efficient way to protect a portfolio of tradable securities from exceptional losses, as any investor can define the maximum drawdown (based on his risk bearing capacity) of the tradable securities in a portfolio by setting respective stop-loss orders.
As it can be quite time consuming and complex to keep fixed stop-loss limits up to date in a portfolio with multiple constituents, investors should use trailing stop-loss orders instead. This kind of stop-loss limit follows the price of a security in a pre-defined percentage interval measured from the price from the date when the trailing stop-loss limit was set. This means once set, an investor doesn’t has to look after his stop-loss limits until they expire.
That said, stop-loss limits have a big flaw. It is not guaranteed that the stop-loss limit will be executed on the price of the limit since there might be no liquidity at the given price or the price of the respective security falls to fast. In these cases, the stop-loss order will be executed at the next possible price. Unfortunately, this price can be way below the expected stop-loss limit. Even as this is mostly the case for securities with an in-general low liquidity, it can also happen when a security has normally a decent or high liquidity.
In addition, investors need to remember that they have to invest the resulting cash from the stop-loss orders back into the markets when they feel confident to do so.
Otherwise, their portfolio would no longer fit their strategic asset allocation. In turn, this means the cash from stop-loss orders needs to be seen as part of the tactical asset allocation.
This article is for information purposes only and does not constitute any investment advice.
The views expressed are the views of the author, not necessarily those of LSEG Lipper or LSEG.
