If you listen to CNBC or to some of the so-called experts, they expound to you the virtues of setting stop losses. It seems so reasonable, so logical. But do they work?  No! Allow me to explain.

Let’s assume that you buy 100 shares of a stock priced at $40, an out-of-pocket cost of $4,000. You want to make 20% on your purchase, but you do not want to lose more than 10%. If you set a stop loss of $36, you cannot lose more than $400. Sounds great, doesn’t it? Let us say that the stock begins the day by dropping to $36; you are immediately stopped out with your loss of $400. But after the stock drops to $36, it rebounds and ends the day at $43 per share. But your stop-loss took you out of the game already. To own the stock now, you have to put up the $3,600 you received when stopped out, plus an additional $700 to buy the 100 shares at $43. That stop loss just cost you $700 to own the same 100 shares. You think you own the shares at $43, but the reality is you paid $47 per share (the original $4,000 plus the additional $700).

This is a simple example to illustrate the fallacies of the stop loss. What seems so logical and so reasonable is a losing proposition. You can make it more complicated, you can buy a different stock, you can extend the period, but if the stock has a drop before it increases, you will always take a loss.

To make matters worse, most investors and financial advisers do not compare the returns in their portfolios to an index like the S&P 500 TR (with dividends reinvested). Most will think they own the stock at $43, forgetting the $400 loss.

I always wondered why, during the era of Peter Lynch, the portfolio managers at Fidelity never managed to get similar returns. Peter Lynch achieved an average 29% return over the thirteen years he managed the Magellan Fund. The other portfolio managers had the benefit of working with Lynch and listening to his logic. I will never know why those managers did not achieve similar results, but I wonder if they did not get caught up in stop losses or trying the time the market by selling when the market was falling and trying to buy back in when the market was rising.

Lynch was famous for saying, “If you can’t convince yourself “When I’m down 25 percent, I’m a buyer” and banish forever the fatal thought “When I’m down 25 percent I’m a seller,” then you’ll never make a decent profit in stocks.” Peter Lynch did not use stop losses. He rode his portfolio down as low as 40% to 50% at times, and still, over that thirteen-year period, turned $500,000 into $8,385,000!  

I would guess Lynch knew that stop losses are aptly named “losses”. They build in realized losses.

At AFC we stand with Lynch. AFC accepts that there will be times when we experience periodic losses, setbacks, and unexpected occurrences. Calamitous drops do not scare us out of the market.