Stops have become nearly ubiquitous these days. It seems like almost every investor uses some form of stop (including us). But there’s an ongoing debate about whether it’s better to use a mental stop (normally a percentage or price you keep in mind that triggers a sell if a stock violates those levels on a close) or a stop-loss order with your broker or trading software (automatically triggers a sell if a stock hits a certain level during the day).
There are good and bad points to each. But the general difference is simply that mental stops tend to do better with a methodology that’s a bit longer term, while in-the-market stop-loss orders are often better for shorter-term, more active strategies that emphasize avoiding much drawdown.
In my Cabot Growth Investor advisory, where we have an intermediate- to longer-term viewpoint, we prefer mental stops. The best aspect of mental stops is that they help you avoid the occasional shakeout during earnings season or when the market goes haywire, which it inevitably does a few times per year.
We frequently see brief high-volume selling and volatility shake out plenty of investors that just happened to have a stop a percentage or two too high. Companies trading with otherwise healthy fundamentals and technicals announce share offerings that cause share prices to fall overnight, or experience some early-morning market panic, causing the stock to plunge 10% at the open. Investors are frequently kicked out of their positions on these moves and are left watching the stock bounce back.
Of course, mental stops aren’t without their bad side, either. Sometimes a stock drops to your stop during the day … and then just keeps dropping for the rest of the day, leaving you with a bigger loss than you planned on. In those situations, in-the-market stops are more fruitful.
In our view, the real key to using stops when selling stocks is twofold. First and foremost, decide which method (mental or stop-loss orders) you like better, and then apply that to all your stocks—don’t use mental stops for some holdings and stop-loss orders for others.
The second key is to add some common sense. If you use mental stops like us, realize that sometimes (like on a truly horrible earnings reaction), it will be better to take action intraday instead of waiting for the close. Conversely, if you have stop-loss orders in place, it’s probably best to pull them just before a company reports earnings and then use some judgment depending on how a stock reacts.
Stops are an important part of any strategy for selling stocks, but you should put some thought into them. We usually prefer mental stops, but have also added some contingencies for when a stock (or the market) completely implodes, which can allow us to get out a bit earlier (and at higher prices) than otherwise.
