Stop-loss orders are one of the most commonly used risk-management tools in investing. In times of uncertainty (which describes most times)—and especially for individual stocks that investors felt emotionally attached to—I would often get the question, "Should I use a stop loss?"
Stop losses are deceptively simple: if you set a price at which you will automatically sell, then you are largely in control of how much downside risk you're taking.
But most investors use stop losses in ways that quietly sabotage long-term compounding.
This article is not about day trading or short-term tactics. It's about understanding when a stop loss can help, when it hurts, whether there is an optimal level and why tight stop losses—especially on broad market indexes like the S&P 500—often produce worse outcomes than doing nothing at all.
To understand why, we need to move beyond intuition and look at how returns actually work.
How Do Stop Losses Work?
A stop-loss order is an instruction to sell an investment once it falls to a predetermined price. The goal is simple: limit downside risk.
For example, if an S&P 500 ETF is trading at $700 and you place a stop loss 8% below the current price, your sell order would trigger around $644.
In theory, this protects you from large drawdowns. In practice, the effectiveness of a stop loss depends entirely on how it interacts with market volatility and human behavior.
That interaction is where most strategies break down.
The Three Drivers of Investment Performance
To examine stop losses clearly, it helps to step away from individual trades and decompose long-term performance into three components:
- Position size
- Win rate
- Payoff ratio (average gain relative to average loss)
Stop-loss design directly affects the last two—and often in opposing directions. Higher win rates come with lower payoff ratios, and lower win rates with higher payoff ratios.
Stop Losses and the Payoff Ratio
At tighter stop-loss levels, the payoff ratio naturally looks attractive.
If your strategy is to take profits at 30% and your stop loss is set 1% below the current price, your payoff ratio is 30:1. You gain 30% when you're right and lose only 1% when you're wrong.
On paper, that sounds phenomenal.
But the payoff ratio only matters in light of the win rate.
Why Tight Stop Losses Crush Win Rates
Here's the catch: the tighter the stop loss, the less often you win.
A 1% stop loss on a broad market index like the S&P 500 is extremely likely to be hit due to normal day-to-day volatility. In practice, such a strategy might only succeed 3–4% of the time.
That means you're trading frequent small losses for rare large gains—and those rare wins may not occur often enough to overcome the constant friction of being stopped out.
The result? An average annual return that can end up around 1% or less, despite a dazzling payoff ratio.
This is the central misunderstanding behind most "best stop loss strategy" discussions. Investors optimize for payoff ratio and ignore win rate.
You can't do that. You need both.
Is There an Optimal Stop Loss Percentage?
That leads to the real question:
Is there a stop-loss level that
- reduces the risk of riding through a full bear market
- helps automate decisions and remove emotion
- and does not materially damage long-term returns?
In research conducted by Xinyu Xiong, quantitative risk professional at Citi, data pulled from 2000–2005—a period that included the tech bubble crash and recovery—suggests that for broad market indexes, yes, there may be an optimal range.
This research has limitations. It has not, to my knowledge, been tested across multiple market regimes. But it offers an important insight: stop losses become counterproductive only when they interfere with normal volatility.
Volatility Matters More Than Fear
As of this writing, the S&P 500 has a 3-year standard deviation of roughly 12%.
In plain language, that means that about two out of every three years, price movement tends to stay within roughly ±12% of its 3-year average return. If the average 3-year return were 22%, then a statistically common range might be something like 10% to 34%.
This is not a forecast, and it should never be used in isolation. But it gives us context.
The S&P 500 regularly experiences 5%–10% pullbacks, often two or three times per year. These moves are not signals of trouble. They are the cost of admission for equity returns.
The Case for an 8% Stop Loss on the S&P 500
Research data on stop-loss effectiveness from Xinyu Xiong of Citi
Against that backdrop, a stop loss around 7%–8% below the current price begins to make more sense for the S&P 500.
Why?
Because it allows normal volatility to occur without stopping you out too early.
An 8% stop loss still carries a high probability of being triggered at some point over time—but not constantly. And crucially, it does not interfere as aggressively with the market's natural rhythm.
Let's say the S&P 500 is at 700. An 8% stop loss would sit around 644.
If the market rises to 730 and then drops 8%, the stop would not trigger on the index fund. Only a drop below 644 would matter. This nuance alone dramatically reduces how often you're forced out of the market.
Now combine that with a take-profit strategy—say, harvesting gains at 30%—and something interesting happens:
Long-term returns do not appear to be severely impaired. In some cases (such as the period tested from 2000-2005), they may even improve slightly.
The Real Problem: Re-Entry
This is where most stop-loss strategies fail—not statistically, but behaviorally.
Most 8% declines recover relatively quickly. Some are shallow pullbacks that return to their highs in just weeks. Others are corrections of 10%–20% that last months.
In either case, getting back in is psychologically harder than getting out.
If an investor were comfortable re-entering quickly, they probably wouldn't have set the stop loss in the first place. Instead, they wait for "confirmation," better news, or stability—often re-entering at a higher price than where they sold.
That single behavior destroys the mathematical advantage of the strategy.
Worse still, 8% drops happen frequently. An investor could experience 10 or more such declines before the stop loss actually protects them from a prolonged bear market.
When considering the question of "should I use a stop loss," this should be considered with the question, "do I have a rules-based re-entry plan?" If the answer to the latter is yes, then it strengthens the case for the former.
Who Should Use a Stop Loss?
Despite the drawbacks, stop losses are not inherently bad. They're just misused.
This type of strategy may make sense for:
1. Investors Who Value Smoother Short-Term Outcomes
Some investors are willing to accept lower long-term average returns in exchange for avoiding deep drawdowns. That trade-off can be rational—especially if emotional discipline is the limiting factor and if they tend to be market timers.
2. Investors Temporarily Hedging Late-Cycle Risk
If you believe markets are in the late stages of a bull run, a rules-based stop loss can serve as a temporary hedge—provided you understand the risks and limitations.
3. Opportunity-Focused Capital
Within The Wealth Expedition, we distinguish between investing for retirement and investing for opportunity.
Opportunity capital often has a 3–5 year horizon—funding a business, a career transition, or discretionary income. Over shorter horizons, hedging risk becomes more strategic and less destructive to compounding.
A stop-loss-based, all-equity approach may, in some cases, outperform a traditional stock-bond mix. It doesn't guarantee success—but potential matters when flexibility is the goal.
Important Warnings
Two critical caveats:
So… Should I Use a Stop Loss?
For most long-term investors, tight stop losses are a mistake.
They reduce win rates, interrupt compounding, and increase the likelihood of selling low and buying back higher.
For disciplined investors with clear rules, realistic expectations, and a defined purpose—especially in intermediate-horizon accounts—a wider stop loss aligned with market volatility can be a useful tool.
But the real lesson is this:
Avoiding normal downside risk often means giving up extraordinary upside.
And no stop-loss strategy can change that fundamental truth.
Wealth isn't just about minimizing downside risk.
It's about making decisions which stack the odds in your favor—carrying you toward your destination on time.