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Triggering a Collapse

Stop-loss orders make no sense, especially in the case of long term investors

For a brief half hour or so, it was back to the bad old days of October 2008. It's like you woke up from a bad dream but later realised that the bad dream was reality and the waking up was the dream. On Thursday last week, in about half an hour, the US stock markets crashed by about 6 per cent, over and above the 3 per cent that they were already down for the day. Even though they recovered somewhat later in the day, the rate of fall was worse than anything seen during the worst days of 2008 or 2009. In fact, even after the partial recovery, that one day was worse for the US markets than anything since 1987.

The curious part is that even now, a few days later, the exact reason for this crash is a bit of a mystery. So inexplicable was the drop that initially, almost everyone suspected some sort of a systems problem at the stock exchanges. However, it seems that the price drop was genuine, in the sense that it really was a result of a match between buy orders and sell orders at a price agreeable to both sides. Unfortunately, these trades were the result of computers blindly executing the same trade strategy being executed simultaneously by a huge number of computers.

All that happened was that when the prices starting dropping, a large number of so-called 'stop-loss' trades were triggered. For those unfamiliar with trading jargon, a stop-loss is a sell order that executes (nowadays, generally automatically) when prices drop more than a certain amount. However, because of the way the US markets work, for a brief period these sell orders were routed to some thinly-traded electronic markets. Stop-loss trades themselves do not have any lower limit. So if the order is configured to sell below a certain price, then it doesn't matter how much below that limit the price is. The order says, "sell below X price". It doesn't say, "sell below X price, but not if the price is so low that is below Y". The result of a huge amount of sell orders hitting thinly-traded markets was that stock prices dropped very rapidly.

Anyhow, the really sad part of the whole story is how widespread stop-loss orders have become not just among traders but even among investors. Apparently, nowadays, even investors who hope to stay in a stock long-term still put in a stop-loss order just in case the market crashes. This is bizarre. A genuine investor who has long-term conviction about a stock should welcome any severe price drop as an opportunity to buy into the stock. He doesn't sell and run the moment the stock drops. If long-term investors also start selling when their stocks drop, then even a routine drop in a stock price could turn into a full scale rout as there would be few buyers left in the markets.

This is what seems to have happened in the US on Thursday. One of the individual stocks that was in the middle of the maelstrom was Proctor & Gamble. At the low-point of the day, P&G was down about 30 per cent. This is one of the world's most stable large-cap companies and in such a company, such a drop is without any justification, no matter what. The kind of investing culture that thinks is okay to run away from any stock regardless of anything else does no good to anyone, be it the short-term investor, the long-term shareholder, or the company.