How online discount brokers can help investors get better returns.

When people buy stocks through an online brokerage, there is always the risk that the stock could lose value.  With the exception of day traders, most people are not watching a stock constantly.  Many times, normal investors may return to their account several days latter to see that the stock has decreased in price and their account has lost value.  One way to address this is through alerts.  If a stock reaches a set value, an email is sent.  Unfortunately, the investor may not get the email quick enough in order to make a sale to prevent further losses.  The other way to solve this problem is by using a stop loss.  With a stop loss, the investor sets the price where they want to sell and then they go on with their life. If the stock drops below the fixed price, the stock is sold automatically.

For many brokerages, setting the stop loss is a two-step process.  First you have to buy the stock then you have to enter a sell order as a stop loss.  If you only want to have 2% loss, you have to calculate the new sale price by hand.

To help customers minimize their losses, brokerages should use the Default Heuristic from Behavioral Finance to automatically set a stop loss.  When someone purchases a stock, a stop loss should be automatically set at a 2% loss.  This allows a little fluctuation after the stock is purchased but still limits the total loss to 2% plus transactions fees. Of course you can always remove the stop loss or change the price.

A 2% Stop Loss for Google

Automatically setting the stop loss prevents two major errors in Behavioral Finance, Loss Aversion and Disposition Effect.  Under Loss Aversion, people treat losses 2.5 times worse than a gain.  The stop loss will help minimize the feelings of loss.  The Disposition Effect states that people sell winners and keep losers hoping that the stock is bound to make up all of its losses.  Setting a stop loss will automatically sell the stock at a 2% loss avoiding the Disposition Effect.  Furthermore, this decision is made when the investor is making rational decisions because they are in a Cold Mood as described by Richard Thaler in his book “Nudge”.

This benefit can be taken one step further by increasing the strike price of the stop loss as the stock gains value.  If the stock increases by 3% from the original purchase price, then the stop loss should be reset at 1% above the purchase price (2% below the current price).  This will lock in any gains that the investor receives.  As the stock continues to increase in value, the stop loss would also continue to increase always trailing by 2%.  When the stop loss is triggered, the investor just needs to reevaluate whether they still want to be in that particular stock.  While a 1% gain does not sound like much, if that 1% was realized in only one month then the stock would have an effective annual interest rate of 8.7%

The Stop Loss automatically Increases with gains.

Using the Default Heuristic, online brokerages like E*Trade and Fidelity could minimize the losses for their customers while helping to lock in any gains.  If someone told me that the most I could lose on an investment is 2% but any gains that I received would be locked in, I would feel very confident about that investment.