Is stop-loss necessary for long-term investments?

Long-term investments have a time span of months or years. The investor knows his money will remain tied up for a long time in exchange, hopefully, for a future pension.

The investor’s doubt is to set a stop-loss to close his trade if his prediction is wrong automatically.

It is different to prevent a stop-loss or leave in the event of a loss from a trade in long-term investments. These are two distinct concepts.

In the first case, someone mathematically decides the stop loss or, technically a previous one. In the second scenario, you change your mind and close the position.

The asset price will fluctuate throughout the trading cycle, and the investor will always be virtually profit or loss. When investing in the long run, the percentage of gain must be adjusted to the investment duration.

Prices fluctuation varies according to the volatility of the purchased financial instrument. For example, buying a stock market index with a time horizon of 5 years can be accompanied by extreme price fluctuations.

If the investment is wrong and the position goes into loss, the investor could consider whether to insert a stop loss and collect the loss. It could also wait to recover the losses and gains in the long run.

It is challenging to close the position to stop losses when investing in the long run, as the price may fall shortly after purchasing the asset. Knowing the psychological aspects behind stoploss is important.

Long-term investments do not require fixed stop losses.

Let’s say we entered the US index market in early 2020. We planned to remain invested for five years and calculate an annual growth of S&P500 of about 7% per year.

Unfortunately, the American index collapsed after Covid-19 after only three months. We have accumulated a virtual loss of 35%. Do we end in stop losses? 

S&P500 chart with huge drawdown in a long term trade
S&P500 chart with the huge drawdown in a long term trade

We could predict a stop-loss equivalent to the hypothesized gain, equal to 7% multiplied by five years. Here, we would have suffered a stop and left the operation as soon as we had reached a loss of 35%.

It is wrong to put a preventive stop in long-term investment.

The key is to predict the volatility of the asset and adjust the correct position size. The investor needs to know the factors that increase market volatility.

By correctly predicting volatility, we will adjust the position size to a falling price. The investor will not have to close at a loss, because the drawdown will be proportionate and budgeted.

Conclusion

The only reason you should close a long-term investment at a loss is when the investor believes his analysis is no longer valid.

In the long run, many factors can change; a trade could contradict central banks’ decisions.  

The motivation behind the investment no longer exists. New analyses are unlikely to make a profit in the future. The investor must resign, cash in on his losses, and seek other profit opportunities in these cases.

By splitting their portfolio with non-related assets and imposing short-term positions for each long-term trade. Decisions based on panic are always a bad idea.

When the analysis is correct, a drawdown should not frighten and should not be a reason for preventive exit from long-term trades.

However, it is essential that the loss, even if virtual, is limited to a small percentage of the total capital and portfolio.

Take the example of Covid-19 and assume you have invested 5% of your portfolio in the S&P500 index. 

If the index fell by 35% in March, we will have a drawback of that position, corresponding to 1.75% of our entire portfolio. Don’t panic; the Fed printed money, there was no need for a stoppage.

I would leave the stop-loss to those who trade intraday with leverage. Intraday trading is an activity that I do not recommend.

The long-term investor will withdraw from the trade if he no longer considers it profitable in the long run, without being influenced by short-term price fluctuations.

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