Q&A: Are Stop Loss Orders Really Necessary?

So I understand that stop loss is used to protect gains/limit loss. But is it really necessary like during a time of crisis? Example: I buy a share of company A for $100 and put a stop loss at $90. Stock closes at $101. Something occurs in premarket, and stock goes down to $80. How has that protected me when it sells at the market open when everyone else is frantically selling?

In the example you’ve outlined, it hasn’t protected you, at least not in the manner you were hoping for. I am an enthusiastic proponent of setting pre-defined protective exits, but will be the first to tell you that they are not perfect.

Investing is a process of making decisions in an environment of uncertainty. Everything we do is a tradeoff. For example, a stop loss order on an ETF of technology stocks will be more reliable than a stop loss order placed on a single technology stock. Which is more important to you – more reliable risk management or greater upside potential? Whichever way you pick, prepare to be disappointed at times.

Not placing a stop eliminates the risk of executing the sell order in your example, but doesn’t change the fact that the stock cratered on the open. Are you better off without the stop? Maybe. Maybe not. You’ll only know in hindsight.

The risk of something like your scenario has to be weighed against the advantage of using stops, not just in a single circumstance, but across a large sample size of investments. The best we can do is find compromises that we can live with and concede that whatever we do will be flawed. This is the hardest part of investing for most people – living with the flaws.

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