As an investor, it’s essential to understand that risk assets come with no guaranteed returns. Setting and following a stop loss can help protect your capital, especially if you’re an active investor who picks individual stocks. Without stop losses, you could expose yourself to significant losses.
Yet, I’ve come to realize that stop losses aren’t only useful for active investors—they can be applied to many other aspects of life as well.
If you’re a long-term, passive index investor, you might not need a stop loss, as broad stock indexes aren’t likely to go to zero. Unlike individual companies, indexes don’t face the risk of going out of business, so losing your entire investment is less of a concern.
Let’s break down the concept of a stop loss, explore a couple of examples with investing and poker, and finally, look at how stop losses can enhance other areas of life.
What Is a Stop Loss?
A stop-loss is a broker-placed order to sell a security once it hits a specified price, primarily to limit potential losses. For example, if you purchase a stock at $50 and set a stop loss at $40, your shares will be automatically sold if the stock drops to $40, preventing further loss.
The stop loss reflects the humility to recognize when your investment thesis is flawed. It takes discipline to accept your error and sell before losses deepen.
Value Traps and Stop Losses
If you’re a value investor, a stop loss can be particularly valuable. You’re often drawn to stocks that have corrected, believing the company isn’t fundamentally broken and that management will eventually turn things around.
But stocks often correct for a reason. When you’re buying into negative momentum, the stock can continue to slide, resulting in a “value trap.” Even if the price seems low, earnings could
