Do Stop Loss orders make sense even though they increase volatility?

Question

If most people add Stop Loss orders to their portfolios, then when the market "corrects", then all these SL triggers will fire, but there won't be enough buyers, so prices will fall further, and faster (aka crash). But if I don't add a SL then when the market finally does crash, a la 2000 and 2007 then I've lost a huge chunk of my money when I'm on the down-slope towards retirement. (To clarify: I'm thinking that a "mere" 10% correction would be amplified into a full blown death shock by all the SL orders being fired off.)

How to resolve the herding problem?

Answer 1

There is not really a conundrum here. A conundrum usually describes a difficult problem for particular person. Instead you describe a theoretical example of herding in financial markets and a possible outcome of the herding.

You are correct in that if a (very) large amount of participants all decided putting a stop loss on their portfolios at the same loss point it could be very disruptive to the market. The theoretical situation you describe, if it were to exist, wouldn't really cause a "spiral" downward more of a large "shock" until enough buyers could be found at a low enough price.

However, think about it this way. If you knew that most people were putting stop loss orders in at, for example, -10% less than the current value. It would likely make it worth your while to put in your stop loss at -9% or maybe put a buy order in at -15% (-20%?) to take advantage of the likely overcorrection... Maybe the next person starts putting their stop losses at -8% to take advantage of the -9% people and so on and so on ... until the market self corrects from all these different trades and becomes its usual craziness rather than the particular theoretical craziness you describe.

So, put in your stop loss with not too much fear (but maybe some fear) that most of your neighbors are putting the same stop loss order at the same time for the same amount. Though please don't take this as a endorsement of stop loss orders. They might be the right solution for you or that stop loss order may well lock in your losses or it may cause you to sell when the spread is huge or ...