As an investor, it’s essential to understand that risk assets come with no guaranteed returns. Setting and following a stop loss can help protect your capital from significant losses, especially if you’re an active investor who picks individual stocks.
Yet, I’ve come to realize that stop losses aren’t only useful for active investors—they can be applied to many other aspects of life as well.
If you’re a long-term, passive index investor, you might not need a stop loss, as broad stock indexes aren’t likely to go to zero. Instead, you should probably dollar-cost average during sell-offs.
Let’s break down the concept of a stop loss, explore a couple of examples with investing and poker, and finally, look at how stop losses can enhance other areas of life.
Last call: For those with over $250,000 in investable assets, there’s still time to get a free financial consultation with an Empower professional. If you complete two video calls by October 31, you’ll also receive a $100 Visa gift card by email in November. There’s no obligation to use their services, but a second opinion could be the insight that makes all the difference.
What Is a Stop Loss?
A stop-loss is a broker-placed order to sell a security once it hits a specified price, primarily to limit potential losses. For example, if you purchase a stock at $50 and set a stop loss at $40, your shares will be automatically sold if the stock drops to $40, preventing further loss.
The stop loss reflects the humility to recognize when your investment thesis is flawed. It takes discipline to accept your error and sell before losses deepen.
Value Traps and Stop Losses
If you’re a value investor, a stop loss can be particularly valuable. You’re often drawn to stocks that have corrected, believing the company isn’t fundamentally broken and that management will eventually turn things around.
But stocks often correct for a reason. When you’re buying into negative momentum, the stock can continue to slide, resulting in a “value trap.” Even if the price seems low, earnings could be permanently compromised, making the valuation higher than it appears.
IBM was a classic value trap from 2014 through 2023. Similarly, AT&T has been a laggard since the global financial crisis. While AT&T at least paid a high dividend yield, it’s still been a lackluster performer.
Is Nike a Value Trap?
I allocate around 30% of my cash flow to individual stocks, aiming to find S&P 500 index outperformers that will accelerate wealth creation. Having spent 13 years in equities and living in San Francisco, I can’t resist the appeal of individual stock investing.
After all, almost everyone I know who achieved extraordinary wealth did so through investments beyond index funds. But there’s a catch—most active fund managers still struggle to outperform the index. It’s a tricky balance.
As a new investor in Nike in July 2024, buying in the low-$70 range, I wonder if I’m making a mistake. At the time of this post, the stock is down about 11% over the five-year span from October 2019 to October 2024—a disappointing performance.
Still, I’m buying because:
- I love Nike’s products since 12
- There’s a new CEO
- They’re reclaiming retail space and enhancing online buying experiences
- New technology and more affordable products are on the horizon
- Their NBA contract was renewed
- They have potential to move into pickleball, the world’s fastest-growing sport
Historically, Nike’s 10-year average price-to-earnings (P/E) ratio is 36.29. Currently, it’s 22.46, which is about 38% lower than the historical average—not cheap, but at least relatively discounted. At its peak in November 2020, Nike’s P/E ratio hit 74.42, with a share price of $134.7 and earnings of $1.81.
Because Nike could still be a value trap, I’ve set a stop loss for half of my shares at $70. If Nike breaks this level, it could signal further declines or a prolonged period of “dead money.”
My stop loss not only limits my downside but also minimizes the opportunity cost of potentially missing out on other investments. If the S&P 500 bull market continues, holding Nike instead of an index fund would amplify my losses.
Using Stop Losses in Poker
Beyond applying stop losses in investing, you can also use them in poker to limit your downside.
In a previous post, I mentioned sometimes feeling overwhelmed in semi-retirement with so many activities in limited time. This was exactly the case when I went to a friend’s house for poker after putting the kids to bed by 8:45 pm on Saturday. Since I had pickleball at 7 am the next day, I planned to leave by 1:30 am to get at least five hours of sleep.
My two poker stop losses were losing no more than $300 and leaving no later than 1:30 am.
Among my poker friends, I’m known as a tight player—an image I’ve cultivated to bluff more effectively. In reality, I’m an aggressive player who bets big when probabilities are in my favor. If you play against me, you better be ready to risk your entire stack.
Putting Pressure on My Opponent
At 1 am, sitting in the big blind, I looked down at pocket threes. A decent pre-flop but mediocre hand post-flop.
The blinds were $0.50/$1.00, and after a $5 raise and a call, D—the maniac on the button—raised to $18. I decided to re-raise him to $100, leaving me with just $40 left, hoping to take down the pot for a $28 gain. The $5 raiser and caller folded, but Dan deliberated, then put me all in for $140.
Given I was pot committed and still thought I was ahead, I called, assuming he held overcards like Ace-King and was a slight underdog.
The Coin Flip: Playing the Probabilities
Pocket threes versus Ace-King is a classic “coin flip.” My pocket threes had a slight edge:
- Pocket Threes: ~52.5%
- Ace-King: ~47.5%
With pocket threes, I had a slight advantage as they’re already a made hand, while Ace-King is still looking to connect with the board.
Instead of showing Ace-King, D showed Ace-8 of diamonds—a weaker hand but true to his maniacal style.
The Flop Comes
While the hand unfolded, I went to the bathroom, telling the dealer to proceed. But the dealer purposefully waited for me to heighten the drama.
Once I returned, he dealt the flop: 4, 10, 5, putting me in the lead with a 74% chance of winning. But on the turn, an 8 crushed my hopes as D’s Ace-8 paired up, leaving me with only a 5% chance to win unless I hit a 3 on the river.
A Poker Stop Loss Offer
Feeling defeated, I was suddenly offered a stop loss by D. He offered to split the pot 75%/25% in his favor. Since 25% was better than my 5% chance of winning, I took back $75 while D kept $225. What a gift!
Feeling relieved about losing just $65 instead of $140, I watched the dealer rabbit-hunt the river—a 3! Ugh. I would’ve won the entire $300 pot if he’d just dealt it out while I was taking a piss.
In poker, like investing, stop losses can sometimes backfire. It’s like selling Meta shares at $200 in 2022 after their peak of $376 in 2021, only to watch the stock soar past $570 later.
Overriding My Stop Loss for When to Go Home
I intended to leave at 1:30 am, but stubbornly stayed, determined to recoup my losses. Two hours later, at 3:00 am, I finally busted D and left as the big stack of the night. I paid for my stubbornness with only three hours of sleep before pickleball and needed a couple of days to catch up.
Fortunately, I had worked ahead and scheduled my newsletter for 4:30 am Sunday. Even with a stop loss in place, you might still ignore it out of sheer stubbornness.
Using Stop Losses To Improve Your Life
Now that I’ve shared a few financial applications for stop losses, let’s look at how we can apply the concept to enhance different areas of life.
Stop Losses with Friends: You might set a limit of five insults from a friend. After that fifth insult, you walk away from the relationship and focus on healthier connections.
Stop Losses in Career Growth: You could establish a limit of two missed promotions. If you’re passed over twice, it’s time to update your resume and explore new opportunities.
Stop Losses with Prospective Clients: Set a limit of three unanswered follow-ups with a prospective client. After the third attempt with no response, move on to other potential clients.
Stop Losses in Recreational Sports: Maybe you set a stop loss of two losses in the #1 doubles position. After the second loss, you and your partner shift to #2 doubles. Or in a baseball game, after two errors at third base, you switch to second base.
Stop Losses with Family Planning: For couples struggling to conceive, you might set a stop loss of three IVF cycles at $20,000 each. If unsuccessful, you shift to other options, such as adoption or getting a dog, to protect your finances, mental well-being, and physical health.
Stop Losses in Growing a Business: Set a time limit of three years to become profitable. If the business isn’t generating profit by then, you may consider getting a steady job to safeguard your financial stability.
Stubbornness and Delusion: The Enemies of Progress
One of the biggest risks in both investing and life is stubbornness and delusion. We sometimes convince ourselves that we know more than we really do. Despite a history of underperforming returns, active investors might still believe they can beat the market.
As we pursue financial independence, it’s critical to recognize our own limitations. If your active returns are consistently weak, stop picking individual stocks. Instead, invest in index funds and achieve growth steadily.
This same principle applies to personal choices. Stubbornness and delusion can cause us to hold on to toxic relationships or chase unfeasible goals, rather than moving forward with clarity. Embracing reality and taking calculated steps to adjust is key.
The Benefit of Accepting What You Don’t Know
Since we can’t predict every factor in risky investments, setting a stop loss can help manage our blind spots and protect us from ourselves. Key points of stop losses include:
- Automatic Execution: The set price triggers a market order, executing the sale at the best available price.
- Risk Management: It allows for downside protection without needing constant monitoring.
- Flexibility: Stop-loss orders are adjustable and useful in volatile markets for locking in profits or minimizing losses.
As you build more wealth, a primary rule for financial independence is to avoid catastrophic losses. Large losses not only affect your capital but can cost you something even more valuable: time.
It takes a 100% gain to recover from a 50% loss but only an 11.2% gain to recover from a 10% loss. With stop losses, you’re better protected and can ensure you’re consistently moving forward.
Openly Seek The Opinions Of Others
The easiest way to avoid ever saying, “If I knew then what I know now,” is by seeking the opinions of those who’ve been in your shoes. We all have blind spots that could benefit from outside insight, which is why I enjoy reading the perspectives of Financial Samurai readers.
In early 2013, even with 13 years of experience in equities, I sensed something was off with my investments. I’d left my job just eight months earlier, and although I was careful, I was still playing it too safe—52% of my net worth sat in cash. Speaking to a financial professional helped me understand I could take on more risk while still being smart about it. That conversation added over $1 million to my net worth over the next 11 years.
In today’s bull market, many of you might feel invincible with portfolios riding high. Maybe you’re even starting to feel like an investing genius. But it’s during these times of overconfidence that an objective review is invaluable.
Consider asking your partner, a knowledgeable friend, or a professional to review your net worth and investments—just as you’d get a second opinion before surgery. If the market turns, you’ll be better prepared. While those who’ve ignored the risks may find themselves caught off-guard with few ways to recover.
Readers, do you use stop losses in investing and in aspects of your life? If so, how do you use them?
Get A Free Financial Checkup
Last call: For those with over $250,000 in investable assets, there’s still time to get a free financial consultation with an Empower professional. If you complete two video calls by October 31, you’ll also receive a $100 Visa gift card by email in November. There’s no obligation to use their services, but a second opinion could be the insight that makes all the difference.
The statement is provided to you by Financial Samurai (“Promoter”) who has entered into a written referral agreement with Empower Advisory Group, LLC (“EAG”). Click here to learn more.
To achieve financial freedom sooner, join 60,000+ others and sign up for my free weekly newsletter. Everything I write is based off firsthand experience given money is too important to be left up to pontification.
Read the full article here
