Could fund investors profit from a stop-loss strategy?

Investing famously puts your capital at risk, which is why some investors use a stop-loss strategy to mitigate against heavy share price declines. A stop-loss is an order placed on your trading platform to sell a share automatically if it falls below a certain price.

As its name implies, a stop-loss order is designed to limit the loss you might suffer on an investment. So if you set a stop-loss order for a share at 10 per cent below the price at which you bought it, the order should ensure you don’t lose more than 10 per cent of your investment.

Traditionally, stop-loss strategies are used for share investments, and trading platforms generally have an inbuilt optional stop-loss function. But investors who opt for investment trusts and exchange traded funds could also benefit from a stop-loss function, because these also have a share price. It is conceivable that an index fund could drop by 10-20 per cent in one day, so investors could implement their own stop-loss by selling out at a certain pre-decided price level.

Stop-loss drawbacks

Of course, a stock market could in theory drop dramatically by 10 per cent and then shoot back up, in the process wiping out losses and even making new gains almost as quickly. Arguably, if a stop loss is set at 10 per cent below a share’s initial price, investors risk losing out in such times of high volatility. They could fall victim to the biggest investment vice of all: selling low. Moreover, they could be charged avoidable transaction fees for selling and then re-buying.

Implementing a stop-loss could also mean investors have to pay capital gains tax (CGT) if the sale of the holding crystallises gains above their annual CGT exemption allowance (£11,700 in 2018/19). Having a stop-loss strategy is also somewhat at odds with the advice that people shouldn’t panic during a downturn but sit it out instead, because a well-diversified portfolio of funds tends to recover over time.

However, some financial advisers disagree with this assessment. Brian Dennehy, managing director at FundExpert, argues that fund investors must have a stop-loss strategy – a strict discipline to sell a fund when it is falling – in place to avoid the ‘Japan problem’. In the 1990s investors lost a substantial amount of their savings investing in the declining Japanese stock market, which has still not recovered to its previous level.

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One could counter that this will not apply to a globally invested portfolio, because each region and asset class will be affected differently. After the Brexit vote, for example, UK funds were hit hard, while global funds rose. And even the global financial crisis of 2008 only hit well-diversified portfolios of funds (or global index trackers) for a few years before they recovered. The FTSE World index, for example, took less than three years to return to its pre-crisis level in total return terms.

But Dennehy says: ‘The problem with diversification is that during the worst periods for markets, nearly all asset classes around the globe can fall sharply at once – this was the lesson of 2008. No one has any idea what the future holds.’ He argues that one thing we all learnt from the financial crisis is that everything can go down simultaneously, so ‘the value of diversification is greatly overstated at major turning points’.

He maintains that: ‘A contingency plan mustn’t simply allow for what has been experienced, but also for what hasn’t been experienced but is possible.’ It is not the predictable but ‘the unpredictable that destroys financial plans’. Thus, he concludes: ‘In a nutshell, the most effective stop-loss method is selling on a 10 per cent fall.’

On the other side of the stop-loss argument, we find Pat Connolly, certified financial planner at Chase de Vere. ‘We don’t use stop-loss strategies with our clients; in fact we do the complete opposite,’ he says. If any of the asset classes held fall by 10 per cent or more, Connolly and his colleagues don’t sell out. He explains: ‘Instead, we are likely to invest more through rebalancing, where we take profits from investments that have performed well and reinvest in those that have performed badly.’

He argues that not only does rebalancing ensure clients don’t take too much risk, but also that – by selling investments that have done well in favour of those that have done badly – they ‘effectively sell at the top of the market and buy at the bottom’. He adds: ‘This is the holy grail of investing and something very few investors consistently achieve.’

In between the two sides of the debate – of stop-loss aficionados and naysayers – lies a sea of nuanced considerations. It’s understandable that investors are tempted to set a manual stop-loss to protect a portfolio from plunging when the next crisis strikes. ‘Advisers don’t have eyes in the backs of their heads, so stop-losses can help manage risk,’ says Russ Mould, investment director at AJ Bell. However, they are not a perfect solution and need to be considered carefully.

Mould argues that if you set the stop loss too near the current price – say 10 per cent or even 20 per cent below it – there is always the risk that a sudden market stumble or even a ‘flash crash’ will take you out of a position when nothing has fundamentally changed, the invested business remains sound and your initial thesis is intact.

Moreover, he says: ‘A stop loss [order] does not guarantee you will get out at the set price.’ An equity could, for instance, fall below the price you have set as a stop loss and trigger a sale at that lower point. Meanwhile, funds are only traded once a day, which could mean a delay of hours or even a full day in selling.

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He adds: ‘In extreme circumstances, a profit warning could drive a firm’s share price down by 40 per cent or more at the opening, so that your stop loss is executed at the first best-available price.’ While this might be helpful, an investor could take the view that such a huge drop is an over-reaction by the market and, more sensibly, represents an good opportunity to buy additional stock cheaply.

‘With volatility in markets having been unusually subdued for so long, asset prices having risen for so long almost across the board (almost nine years now) and interest rates poised to inch higher on a sustainable basis for the first time in more than a decade, it seems likely that share (and bond and commodity) prices and currencies are going to gyrate a lot more than they have done over the past year or two,’ Mould concludes.

Therefore, a more moderate view on stop-loss strategies is that they might make sense, but only in certain circumstances: if an investor is in drawdown and looking to preserve capital and manage risk, for example.

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Another consideration is that the new Mifid II regulations introduced at the start of this year mean that many discretionary advisers have to notify investors as a matter of course when their holdings fall in value by 10 per cent, says Philippa Gee, managing director at Philippa Gee Wealth Management.

‘The trouble with that notification is that it can crystallise the loss in the client’s mind and may result in unnecessary action,’ she says. ‘Also the adviser may feel the need to demonstrate that they are adding value for the fees charged and therefore feel compelled to take action at that point.’

She observes that the time to take action in response to stock market volatility ‘is before falls have happened, and not once they have happened’. Given that asset allocation and fund selection should be the first steps in determining risk, a nervous investor could, for example, take steps to lower equity exposure. She says: ‘It shouldn’t usually be about a stop-loss policy, but instead about making sure investments are always suitable for you and your objective.’

Making investment decisions in the middle of market turbulence is something investors might regret. ‘If you did then move to alternative investments via a stop-loss order, what would you then do when markets stabilised? Move your investments again?’ asks Gee. Instead, she suggests a regular review of your risk tolerance, investment timeframes and objectives, and ‘always, always making investments relevant to you’. 

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