Warren Buffett said investors shouldn’t dream of owning a stock for ten minutes that they wouldn’t own for ten years. That rule should double for exchange-traded index funds (ETFs). Instead, investors hit ETFs back and forth like table tennis players. High frequency trading institutions make every ball a blur. Not every investor trades. Many buy and hold. But some—without realizing it–feed their brokerages batty instructions that could cost them 25 percent or more in a single trading day.
I’m talking about stop loss orders. At first glance, they look safe. When investors set a stop loss order they are instructing their brokerage to automatically sell their investment if it drops to a certain point. That safety, however, can be an expensive illusion.
Here’s how. As I write, Vanguard’s Total Stock Market Index ETF (VTI) trades at $105.31. Investors not wanting to lose more than 10 percent could set a stop loss order at $95. If the ETF dropped to $95, the brokerage would sell it. In theory, this could protect the investor if the index kept falling. They could then buy the index back (at a lower price) and make big bucks when the market rises.
Stop loss orders are like vehicle air bags. They’re marketed for safety. But for a child riding shotgun, they can be deadly. On May 6th, 2010 Vanguard’s Total Stock Market Index ETF (VTI) opened at $56.62. Assume that Joe Investor bought shares and set a stop loss order at $45. Joe would have been robbed during market hours, while he was at work. A mid-market crash and (perhaps) a technological glitch on May 6th caused Vanguard’s index to tumble almost 48 percent, from $56.62 to $29.76. Joe’s stop loss order would have been filled at $45. The index closed for the day at $57.71.
Vanguard’s Total Stock Market Index ETF
Dropped 48% In Mid Day Trading May 6, 2010
Five and a half years later, Vanguard’s Total Stock Market Index ETF has gained 82 percent. It hasn’t come close to hitting $45 again. In this case, the stop loss order would have kicked Joe Investor in the groin.
The Securities and Exchange Commission and its Commodity Futures Trading Commission tried to explain the reasons for the flash crash in a joint report. Whether you blame high frequency trading, massive automatic stop loss orders or computers flipping out, the results are the same. ETFs can move, short term, like a grand mal seizure.
Some market experts, however, said it couldn’t happen twice. They were wrong. Hapless Joe wades back into the market. He buys Vanguard’s Total Stock Market Index ETF once again, paying $108 per share on August 5th, 2015. This time, he sets a stop loss order (Joe isn’t smart) at $93 per share because he doesn’t want to lose more than 13 percent.
On August 24, 2015, Vanguard’s Total Stock Market Index ETF (VTI) fell from its daily market high of $101.37 to $93. By day’s end, the index had almost recovered fully. Hapless Joe, however, would have been forced to sell at $93.
A mini flash crash repeated itself, and Joe paid the price once again.
Other ETFs got knocked to their knees before rising again by the end of the day. The iShares Select Dividend ETF (DVY) dropped 36 percent. The Guggenheim S&P 500 Equal Weight ETF (RSP) fell 42 percent and the iShares Conservative Allocation Fund ETF (AOK) tumbled 49 percent. Investors with stop loss orders could still be on the canvas.
So is ETF investing getting riskier? I don’t think so. Yes, the slew of market glitches, high frequency traders and institutional stop loss orders might curl your toes if you happen to catch an hour of market price madness. But real investors ignore hourly, weekly and monthly price moves. They keep their eyes on the long-term prize. They don’t speculate. They diversify. They control their fees and rebalance once a year. A tool, like a stop loss order, can knock down a chump. But if you sidestep this punch, you can stay on your feet.
Andrew Hallam is a Digital Nomad. He’s the author of the bestseller, Millionaire Teacher and The Global Expatriate's Guide to Investing: From Millionaire Teacher to Millionaire Expat.