While they may not enhance returns, stop losses enhance client well-being and may keep a client from selling what is otherwise a great long-term investment, writes Joachim Klement, CFA, in a recent issue of Enterprising Investor.
A stop loss is an order to sell a security or commodity at a specified price in order to limit a loss. According to Klement, even sophisticated investors fret when markets decline and losses become substantial, and these worries can turn into asset outflows. While stop losses can effectively curtail the bleeding in market declines, they can also lead to client exodus. Klement writes, “I prefer a suboptimal portfolio and a client rather than an optimal portfolio and no client.”
The question, he says, is at what point to re-enter the market after selling. “As a money manager,” he says, “being stopped out of an investment provides the opportunity to reassess the investment case without the potentially harmful influence of the ‘endowment effect'”— assigning a higher value to assets we own compared to those we don’t.
“Of course,” Klement argues, “it could well be that the fundamental case for the investment hasn’t changed. Then the question becomes whether to enter into it again.” He suggests; (1) looking for changes in momentum for clues, or (2) using inverse stop losses to trigger a purchase if an investment rises above a certain level.
“Both of these techniques,” he says, “have helped increase behavioral alpha for both my clients and myself.”