Stop! In the Name of Loss

"Don't invest more than you can lose. The market is a risky place."

Has someone ever told you something like that? When I became interested in investing, my grandmother, who had done fairly well with her investments, gave me that advice. Of course I didn't want to lose money (who does?), so I did some reading and quickly came across the idea of a "stop-loss" order. This type of order automatically sells the stock if the price drops to a certain level or by a certain percentage.

"What a great idea!" I thought to myself. "Something that limits my downside!"

For many investors, the proxy for "risk" is "volatility." The thinking goes that if you don't want to lose money (Warren Buffett's first rule of investing), you should try to minimize volatility. And since a stop-loss order gets you out when the price goes down, many investors employ stop-losses to keep them from losing money.

The dangers of stop-loss

But let's see how that idea works out in practice. Here's a table showing the returns you would have if you'd bought the following companies on Jan. 2, 2003, and then sold after the first 15% decline, along with how long that took. Compare that with the returns if you had just held on through the "bad" times.

Doesn't compare too favorably, does it? Rather than limiting downside, it seems to be limiting upside.

Wait a second ...

I can hear some people saying that it's possible to get back in when the stock begins to go back up. But how would you know when to get back in? And even if you did, no stock climbs steadily upward. Altria, for example, would have triggered sales four separate times in 2003 alone using a 15% stop-loss strategy.

Furthermore, trades cost money. You've paid commissions to repurchase the shares, as well as the commissions for every stop-loss sale. Both eat into your overall returns. Finally, note that every single one of those sales came within a year of buying, triggering short-term capital gain taxes on each. That also hurts.

The only real winners in this scenario are your broker and the IRS.

Try this instead

Instead, the way to limit risk is to pick good companies, buy them to hold, and continually learn about their businesses. This is what we do over at Motley Fool Stock Advisor. There, Fool co-founders David and Tom Gardner recommend only companies with excellent long-term prospects, and our community of thousands of Fools actively follows each recommendation on our dedicated discussion boards. The knowledge gained there leads to more confident investing and the ability to understand and ride out temporary declines. And because some declines are inevitable, Stock Advisor members can either ignore them or use them to buy more shares and supercharge returns.

Together, in the four-plus years of the service, David and Tom have average returns of 58%, compared with just 20% for the S&P 500, with many members doing even better. If that sounds like a good deal to you, click here to try the service free for 30 days. You have nothing to lose.

Fool contributor Jim Mueller does not own shares in any company mentioned, though he is an avid customer of Barnes & Noble. Netflix and eBay are Stock Advisorrecommendations. The Fool has an ironclad disclosure policy.