📅 Updated March 2026: the principles outlined here remain fully relevant. The stop loss strategy proved particularly effective during the corrections of 2022 and 2025.
When a stock goes into freefall, every investor faces the same dilemma: should you sell to limit losses, buy more to take advantage of the lower price, or hold your position? In this article, discover how to combine fundamental analysis and a stop loss strategy to effectively protect your stock portfolio.
It sometimes happens that a stock heads south just after you've bought it. Other times, you've held a position for a long time and built up a substantial gain — and then it starts sliding. In both cases, you're left unsure of how to proceed. Should you buy more to lower your average cost? Sell to avoid further losses (stop loss)? Or simply do nothing?
Most of the time, the last option is the best one. Prices are erratic in the short term. They move for reasons that have more to do with crowd psychology than with the intrinsic value of companies. If you sell at that point, there's a good chance the price will rebound immediately afterwards. Buying more is an option, but it means increasing your risk by concentrating more assets in a single position. And even if prices follow a random walk in the short run, they sometimes fall for very good reasons.
1. Analyse the fundamentals before making any decision
In all cases, you need to check whether anything has changed in the fundamentals. As long as these remain positive, there is generally no reason to worry. Reviewing the balance sheet and annual results is usually sufficient to form an opinion. Earnings are inherently volatile, particularly in the short term. It is therefore neither useful nor desirable to focus on quarterly or semi-annual results.
The key questions to ask yourself
What does checking the fundamentals actually mean? Here are some straightforward questions to ask:
- Is the company profitable?
- Is it generating positive free cash flow?
- Are earnings growing (or at least stable)?
- Is the dividend growing (or at least stable)?
- Is the payout ratio below 70% (relative to both earnings and free cash flow)?
- Are cash holdings rising (or at least stable)?
- Are margins improving (or at least stable)?
- Is profitability progressing (or at least stable)?
- Is long-term debt declining (or at least stable)?
- Is the number of shares outstanding decreasing (or at least stable)?
The more positively you answer these questions, the more likely it is that the market is overreacting for the wrong reasons. The odds are in your favour that the stock price will recover soon. That said, markets can sometimes take a very long time to correct their mistakes — or they may have spotted a real deterioration ahead of the public, thanks to privileged information. This is precisely the argument chartists use to justify ignoring balance sheets and earnings reports: all the information, they claim, is already in the price.
2. Understanding the momentum effect on stock prices
Research has proven the reliability of the fundamental, value-based approach. Technical analysis, by contrast, has never clearly demonstrated its effectiveness — with one notable exception: the momentum effect. A stock that has over- or under-performed over the past six to twelve months is likely to do the same over the following six to twelve months. This effect is limited to that time window, because beyond it, the reverse tends to occur. It is thought to stem from the time it takes for information to spread from insiders to the broad investing public.
In practical terms, this means that negative events capable of durably affecting a company may begin pushing the stock price down before they become public knowledge — and that this effect can persist for several more months afterwards. In total, this process can last up to two years, when you combine the two 12-month momentum windows.
How can you guard against this? Even after checking the fundamentals, you are not immune to this scenario. Tracking quarterly reports won't help much — you won't get the information before the market does. Worse, it may actually cause unnecessary alarm due to the inherently volatile nature of short-term earnings.
3. The stop loss strategy: protecting your capital
This is where chartists can paradoxically come to our aid. Traders apply the 2:1 rule: if they expect to gain $2, they should not lose more than $1. This ensures that losses remain limited relative to potential gains. To achieve this, they place a stop loss sell order — in this example, $1 below the purchase price — and a limit sell order $2 above it.
This approach makes intuitive sense for traders operating on small price movements over a day or a few days. But how can it be applied to long-term investors expecting gains of potentially hundreds of percent? Even if you're targeting "only" a doubling of your investment over seven to eight years — a perfectly reasonable goal — you would need to set a stop order 50% below your purchase price. That clearly makes no sense.
The 20% rule: validated by research
Research has demonstrated the effectiveness of stop loss orders placed 20% below the purchase price. This strategy becomes even more powerful when the stop level is adjusted upward as the stock price rises — what is known as a trailing stop loss. This method simultaneously reduces risk and improves performance.
Trailing stop loss: a dynamic level of protection
The trailing stop loss is a dynamic variant of the classic stop loss. Rather than staying fixed at 20% below the purchase price, the protection level rises with the stock. If your stock gains 50% in value, the stop loss automatically shifts upward to protect part of your gains. This approach combines downside protection against major declines with continued participation in sustained uptrends.
4. Why sell even when fundamentals are still solid?
This approach may feel counterintuitive for a value-oriented investor. Why sell a stock, sometimes at a loss, when the fundamentals still look healthy? There are two reasons why this strategy works in practice.
Reason 1: avoiding a prolonged slump
Even a fundamentally sound stock can underperform for extended periods. By exiting a position when its momentum turns negative (a loss of 20% or more), you generally avoid a lengthy period of stagnation. You redeploy your capital into better-positioned stocks, which have a high probability of outperforming the one you've exited. Nothing stops you from buying back in later. This is the primary reason why this approach improves overall portfolio performance.
Reason 2: limiting catastrophic losses
Sometimes a stock falls for very good reasons that are not yet public knowledge. By exiting at −20%, you cap your loss at that level. By the time the bad news is fully priced in, the decline may have become far more severe. This is the primary reason why this approach reduces portfolio risk.
Of course, this doesn't work every single time — it's all about probabilities. Most of the time, exiting at a 20% loss is the right move. Occasionally, you will sell and the stock will immediately rebound. It is only by applying this principle repeatedly, across multiple stocks and over time, that you can fully appreciate its validity.
5. Practical implementation: the manual stop loss
Avoiding false signals
To avoid false signals, it is better not to place automatic stop loss or trailing stop loss orders. These may be useful for short-term traders, but over the long run, markets occasionally experience sudden, fleeting dislocations: a price collapses instantly before recovering just as quickly. Being triggered by such an event would be entirely counterproductive.
Recommended review frequency
Instead, review your positions on a regular basis — monthly, for example — to check whether any stock has fallen 20% or more from its purchase price or recent high. If so, sell it manually. The only real risk at that point is the investor's own reluctance to act, rationalised by any number of justifications.
💡 Practical tip: Set a recurring date in your calendar (for example, the first Monday of every month) to carry out this systematic review.
6. Summary: what decision should you make?
Your action plan when a stock falls
When facing a price drop, here is the proven strategy for protecting your portfolio:
✅ If the fundamentals have not deteriorated AND the stock has not fallen more than 20%
→ No cause for concern. Hold your position.
⚠️ If the fundamentals have deteriorated OR the stock has fallen more than 20%
→ It is time to sell.
This strategy requires somewhat more effort than a purely fundamental approach — where you review balance sheets and results once a year. You need to be prepared to monitor your holdings on a monthly basis, and psychologically ready to exit positions you originally bought for very sound reasons that may still hold true at the moment of sale. This approach is therefore more demanding, not just in terms of time, but above all in terms of discipline. That said, for those who can stick to it, the results justify the effort.
Next steps to implement your stop loss
- Identify today the stop loss level for each of your positions (purchase price −20% or recent high −20%).
- Schedule a monthly portfolio review (ideally on the same day each month).
- Prepare yourself psychologically to sell even high-quality stocks if the 20% rule applies.
Frequently asked questions
What is a 20% stop loss?
A 20% stop loss means selling a stock when it drops 20% from its purchase price (classic stop loss) or from its highest level since purchase (trailing stop loss). This rule limits your downside while allowing your gains to run.
Should you use an automatic stop loss order?
For long-term investors, it is better to avoid automatic orders, which can be triggered by false signals (temporary volatility). A manual monthly review is preferable to prevent unnecessary sales caused by normal market fluctuations.
When should you buy back a stock sold via stop loss?
Wait for the price to stabilise and for the negative momentum effect (6 to 12 months) to have run its course. A re-entry signal may come when the price returns to where it was 6 to 12 months ago, suggesting the downtrend is losing steam. Always verify that the fundamentals remain solid before re-entering the position.
Does the stop loss strategy actually work?
Yes. Studies show that a 20% stop loss combined with a trailing stop improves overall portfolio performance while reducing risk. It is a matter of probabilities: out of ten sells, some will be followed by a rebound — but overall, you will avoid the most severe collapses.
Should you check the fundamentals before applying the stop loss?
Ideally, yes. If the fundamentals have clearly deteriorated, selling is warranted regardless of whether the 20% threshold has been reached. If the fundamentals remain sound but the stock has still fallen 20% or more, the stop loss rule still applies — the momentum effect can extend the decline well beyond what the balance sheet would suggest.
Sources and data
- Jegadeesh, N. & Titman, S. (2001). Profitability of Momentum Strategies: An Evaluation of Alternative Explanations — seminal study on the momentum effect, SSRN.
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