Stop-loss and investment returns - Essay Example

Submitted] Stop-Loss and Investment Returns: A Review The article en d "Stop-Loss and Investment Returns"by Emmanuel Acar and Robert Toffel informs the reader on the issue of the appropriateness of employing the stop-loss, buy and hold and profit taking strategies. A 'stop loss' and 'profit take' is a predefined point at which traders will get out of a position in a stock based on the idea that it is not moving in the direction that they had anticipated. The need for establishing and adhering to a reasonable stop loss and taking of profits is said to be important if the trader is going to make profits in the long run.

However, traders have a tendency to stick to their shares even in the face of an imminent loss or gain. That is, they 'buy and hold' shares in the hope of better market outcomes. 'Stop Loss' is generally considered as a more informed choice compared to 'buy and hold' because it is only logical to stop when all evidence to do so are present. Acar and Toffel (2000), however, argues that instead of saving the trader from more severe losses, 'stop loss' actually represents additional cost to the trader.

The researchers analyzed data on market trends using statistical methods and were able to show that there were instances that 'stop loss' was shown to be statistically underperforming as compared to 'buy and hold' especially when the assets exhibit high return on risk ratios. What Acar and Toffel (2000) was telling us was that sticking to market shares is not necessarily an irrational move especially in randomized situations that they claim to be typical of markets. While I do agree that there is always the possibility that shares can have a turn around, I am not inclined to think that the stock market developments are random in nature.

Trading is essentially the assessment probabilities and not a mere guessing game. No matter how scant information is in the stock market, the process of trading is governed by statistical analysis giving us basis for our decisions. There are also cases when the trader knows that something is going to happen in the stock market especially in the wake of new economic legislations or the demise of listed corporations. Acar and Toffel (2000) also compared Stop Loss with another Exit strategy that is Profit Taking.

Take-profit, or limit orders are similar to stop-losses in that they are converted into market orders to sell when the point is reached. The exit point is set above the current market price, instead of below. Profit taking is also a cost to the trader because it prevents him from gaining any more gains from future increase in prices of shares. According to the analysis of the two authors, profit making underperforms buy and hold while stop and loss over performs it in most cases. Basically, holding on to your shares when trends show that it will increase in price works better for the trader than holding it when trends show a continuous decrease in prices.

The work of Acar and Toffel (2000) serves to confirm our notion that the trader needs to sell when he sees that prices are going down and hold on when prices are going up. However, it seems to be lacking in the sense that it did not discuss the proper exiting time. Exactly what time am I to hold to my shares or to let it go Aside from this, it is very important to realize that the work of the two authors serves as a reminder that selling shares is probably the most complex money management decision you will face.

As a rule however, it is the most important. The decision is especially difficult when you are faced with a loss and all you want to do is wait for the shares to return to your buying price. When the shares move away from you, making your loss even greater than you would have ever imagined, it makes the situation even more difficult. Also, when it comes to considering your stock market investing strategy for exiting, what is important is not the manner in which you decide to exit, but the fact that you have a plan in place to advise you when to exit.

What is also important is that you remain consistent in whatever approach to exiting you adopt.