Stop! In the Name of Loss

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

Sound familiar? When I became interested in investing, my grandmother, who had done fairly well with her investments, gave me that very 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 (and not losing money is 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 avoid financial losses.

The dangers of stop-loss
But let's see how that idea works 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. (We've also included how long that took.) Compare that with the returns if you had just held on through the bad times, up until the beginning of the month.

Doesn't compare too favorably, does it? Rather than limiting downside, the stop-loss seems to be limiting upside ... and this table isn't limited to outlandish winners.

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.

Those trades cost money -- you'll pay commissions for each stop-loss sale and subsequent repurchase, and you'll eat into your overall returns. And note that every single one of those sales came within a year of buying, potentially triggering short-term capital-gains taxes on each. The only real winners in this scenario are your broker and the IRS.

Try this instead
To limit risk, pick good companies, buy them to hold for the long term, and continuously learn about their businesses. This is what we do over at Motley Fool Stock Advisor. 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, as we've recently seen, we encourage folks to either ignore them or use them to buy more shares and supercharge returns -- as long as the underlying business remains strong.

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This article was originally published Sept. 9, 2006. It has been updated.

Fool contributor Jim Mueller does owns shares of Netflix but of no other company mentioned. He really should become a subscriber of Netflix. eBay, Coach, and Netflix are Stock Advisor picks. The Fool has an ironclad disclosure policy.