Stop-Losses Aren't Your Salvation

Stop-loss orders are widely embraced by investors, including many RealMoney subscribers. However, that alone doesn't mean they have much merit.

This type of order, which generates an automatic sale of stock when it drops to a predetermined level, is often a tool for technical analysts, who trade only on a stock's chart patterns, not on company fundamentals. But if you're eyeing the bottom line and want to buy a good company at a decent price, stop-losses don't accomplish their intended purpose: They do not stop losses.

Stop-loss orders aren't used for other assets, so why stocks? Is a stop-loss useful when you're trying to sell your home, for example? Of course not. If bids are dropping, no rational real estate owner draws a line in the sand at a 10% decline and automatically sells when the bid falls to that level.

Sellers of privately owned businesses don't use stop-losses, either. Can you imagine a private business owner automatically selling his or her company because an offer arrives that is 10% lower than last week's offer? If that sounds irrational, then why would it make any more sense for an investor in a publicly traded business to use a stop-loss order?

Here's the key: Owners of real estate and private businesses generally have a good idea of what their assets are worth. So a stop-loss is of no utility to them. If you really know what an asset is worth, there's no reason to sell because the current bid is low or going lower. On the contrary, a lower bid is a reason not to sell and instead hold fast to your asset.

On this issue, fundamental investors face a classic either/or dilemma: Either they're sufficiently skilled to know what they're buying and don't need a stop-loss, or they're insufficiently skilled to know what they're buying. In the latter case, maybe it's not in their long-term best interests to make their own capital-allocation decisions.

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Arne Alsin is the founder and principal of Alsin Capital Management, an Oregon-based investment advisor and portfolio manager of The Turnaround Fund, a no-load mutual fund. At time of publication, neither Alsin nor ACM held a position in any securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Alsin appreciates your feedback and invites you to send it to [e-mail]. Click here to receive Arne's latest favorite stock picks from his newsletter, The Turnaround Report.