Even when stock markets are in an upward trend, they are still subject to sharp setbacks, such as the one triggered by the re-election of Barack Obama as president last week. Many investors seek to protect their profits against such reverses though the use of stop-loss orders.

Before you try this approach, you should keep in mind that stop-loss orders have a number of risks that can cost you money. Here’s a look at this investing strategy, and some of the dangers you may be exposed to with stop-loss orders.

Stop-loss orders are a direction to your broker to buy or sell a stock if it hits a specific price.

For example, if you own a $12 stock, you might tell your broker to sell it “on stop” if it hits $10. This may limit your losses if you paid more than $10. If you paid less than $10, it may preserve some of your profits.

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3 ways stop-loss orders can work against you

There are three ways in which stop-loss orders can hurt your returns:

• You could be forced to sell your best picks way too early. If a stock is going to rise from, say, $20 to $100, it will go through many short-term downturns along the way. Some may be $2, some $10, $20 or even more. Investors may avoid some of these declines with stop-loss orders. But they’ll always sell the strong performers when they are just getting started.

You can add a price limit to your stop loss, but that just nullifies the stop as long as the price is below the limit.

• You may not even get your stop price. The triggering of the $10 stop-loss order doesn’t ensure that you will sell the stock for $10. It just means that your broker will put in a “sell-at-market order” for you at that price. If other investors don’t bid anywhere near $10, you could wind up selling at a much lower price. That’s particularly true if the stock is falling sharply.

As well, if other holders put in stops at $10, and many sell-at-market orders hit the market at the same time, everyone may wind up selling for far below $10.

• Here’s one situation in which stop-loss orders could be helpful: At times, mechanical investing aids like stops can work. But most investors who rely on them wind up losing money in the long run. That’s why we’ve long recommended that investors avoid using stop-loss orders, especially on any sort of habitual basis.

However, with speculative stocks, it’s better to use a stop-loss order than to buy and forget it. You can get away with the “buy-and-forget-it” approach for a time if you buy high-quality stocks. But few speculative stocks ever reach that degree of investment quality.

Instead of stop-loss orders, we think you would be far better off sticking with our three-part approach of investing in well-established companies, spreading your money out across the five main economic sectors and avoiding stocks in the broker/media limelight.

This system requires more attention and effort than the simple strategy of issuing stop-loss orders. But it will serve you much better in the long run.

COMMENTS PLEASE—Share your investment experience and opinions with fellow TSINetwork.ca members

Are there particular situations in which you use stop-loss orders to avoid or limit potential losses? On the whole, have you been satisfied with the results? Let us know what you think?