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 discovered  the "stop-loss" order. It will automatically sell a 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. Investors assume that to avoid losing money (Warren Buffett's first rule of investing), they 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 your returns 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 decline took.) Compare those figures with the returns you would have gained by holding those stocks through the bad times, including this year's downturn, up through the end of last 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. Corning, for example, would have triggered sales eight 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, eating into your overall returns. And note that every single one of those sales came within a year of buying, potentially triggering painful 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 continually 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 helps our members understand and endure temporary declines. And because some declines are inevitable, as we've recently seen, we encourage folks to either ignore them, or use them to supercharge returns by buying more shares -- as long as the underlying business remains strong.

Together, in almost six years of the service, David and Tom have averaged returns of 51%, compared with 14% for the S&P 500. If that sounds like a good deal to you, try the service free for 30 days. You have nothing to lose.

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

Jim Mueller does not own shares of any of the companies mentioned. The Fool has an ironclad disclosure policy.