Many investors consider using a stop-loss order to protect their profits, particularly if the market begins to slide down after a period of gains.

A stop-loss order is a specific direction you give a broker to buy or sell a stock if it hits a specific price.

But stop-loss orders have a number of drawbacks that can cost you money.

 If you own a $12 stock, you might tell your broker to sell it “on stop” if it hits $10. This may limit your losses if you paid more than $10. If you paid less, it may preserve some of your profits. Some investors set up up stop-loss orders as a safety net for their investments. Note that you will pay a commission for each buy or sell automatically triggered.

A situation where stop-loss orders could be helpful

At times, mechanical investing aids like stops can work. But most investors who rely on them wind up losing money in the long run. That’s why we’ve long recommended that investors avoid using stop-loss orders with their stock brokerage firms, especially on any sort of habitual basis.

However, with speculative stocks, it’s better to use a stop-loss order than to buy and forget it. You can get away with the “buy-and-forget-it” approach for a time, if you buy high-quality stocks. But few speculatives ever reach that degree of investment quality.

Here are two key drawbacks to the use of stop-loss orders:

1. You could be forced to sell your best picks way too early. If a stock is going to rise from, say, $20 to $100, it will go through many short-term downturns along the way. Some of those downturns may only carry it downward by $2. Some will take it down $10, $20 or even more. Investors may avoid some losses with stop-loss orders. But they’ll often sell the strong performers when they are just getting started.
2. You may not even get the price you set on your “stop”. The triggering of the $10 stop-loss order doesn’t automatically mean that you will sell the stock for $10. Instead, it just means you put in a “sell-at-market order.” However, if other investors don’t bid anywhere near $10, you could wind up selling at a much lower price. That’s particularly likely if a lot of other holders put in stops at $10.

You can add a price limit to your stop-loss. But that just nullifies the stop so long as the price is below the limit.

Key point: Stop-loss orders are one of the many “fits-on-a-T-shirt” investing ideas that work well in theory but cost you money when you try to put them into practice.

Instead of using a stop-loss order, take a more conservative approach and use TSI Network’s  three-part investing strategy. This system requires more attention and effort than stop-loss orders. But it will serve you much better in the long run.

No matter what kind of stocks you invest in, you should take care to spread your money out across the five main economic sectors: Finance, Utilities, Consumer, Resources & Commodities, and Manufacturing & Industry.

By diversifying across most if not all of the five sectors, you avoid overloading yourself with stocks that are about to slump simply because of industry conditions or investor fashion.

You also increase your chances of stumbling upon a market superstar—a stock that does two to three or more times better than the market average.

Our three-part Successful Investor strategy:

1. Invest mainly in well-established companies;
2. Spread your money out across most if not all of the five main economic sectors (Manufacturing & Industry; Resources & Commodities; Consumer; Finance; Utilities);
3. Downplay or avoid stocks in the broker/media limelight.

Do you use stop-loss orders? Share your experience with stop-loss orders with us in the comments.

Note: This article was originally published in 2011 and has been updated.