Evaluating the Value of Stop-Losses & Gains in Enhancing Risk-Adjusted Returns

Interesting paper here on stop-losses and stop-gains in portfolio strategies.  Worth a read (via Abnormal Returns):

“Asset allocation strategies which utilize stop-loss and stop-gain rules may dramatically decrease risk and even increase long-term return relative to passive investing. I introduce an asset-allocation strategy which shifts portfolio weights based on simplistic stop rules. The two-asset (S&P mutual fund and bond mutual fund) strategy tested from 1990-2012 produces an annual geometric return of 8.45% vs. 7.50% for the underlying S&P 500 Index fund, with roughly 50% less volatility (9.45% annualized standard deviation of return vs. 18.76% for the S&P index fund). The strategy’s strong results are robust to changes in the user-specified parameters, such as the level and number of stop placements. Hence, further development and refinement of asset allocation and trading strategies which incorporate stop-loss and stop-gain rules may be a valuable area of future research.”

Cullen Roche

Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services. He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance and Understanding the Modern Monetary System.

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Comments

  1. Ever since the “flash crash” I have been scared to make a stop-loss order on any stock. The possibility that one can be stopped out at zero and the stock recovers only milliseconds later has become very real. There have been recent incidents where this has happened – even in stocks with significant market cap. Maybe a better plan is to set alerts so you can be alerted if a stock is tanking, but don’t put a stop-loss on autopilot.

  2. Hi Cullen,

    The period of 1990 to 2012 is only 22 years and thus far too short to make definitive conclusions about a permanent investment strategy. Much more telling would be what happens in different environments. For examples, how would this strategy have worked during the secular bear markets of 1966 to 1982 and 1929 to 1942? How about during the secular bull markets of 1942 to 1966 and 1982 to 2000?

  3. Really, Stop Loss? You might as well say that you should use dollar cost averaging. (Ask Vanguard on that one)

    Just ask any market maker or brokerage firms. Placing a stop loss is guaranteed money looser for the individual investor. The only way to make money consistently is to reduce your cost basis and use market cyclicality.

    In other words, a true simple strategy for investing is to buy the SPY and sell covered calls that have .37 – .32 deltas out of the money and collect the premium as the stock rises. If the stock falls and continue to sell calls as if falls. This will continue to reduce the cost price of the stock. To make this even simpler, the covered call is the same as having a $2.00 off coupon when you buy the stock. Who wouldn’t want that?

    I’m glad that you get annual geometric return of 8.45% vs. 7.50%. Meanwhile I will get 22%+ real return for the year.

  4. I’m skeptical of stop-losses based on the potential for gap-downs (flash crash, huge gap on the open that then bounces back up, etc) and because it seems like my anecdotal evidence indicates stops happen around the bottom.

    That’s why I was really interested in this paper. Unfortunately, I got to the part about each sub-portfolio having a two-dimensional vector and knew I was going to have to brush up on my maths.