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Truths about stop-losses that nobody wants to believe

 

dearfellowinvestor_s 

 

graph_downIf you're a long-term reader of our articles, or a subscriber to the newsletter, you will know that I have not been a great supporter of using a stop-loss system.

This is mainly been because some testing we did came to the conclusion that a stop-loss strategy leads to lower returns even though it did reduce volatility (large losses).


Why we read all the time?

But you know I look at investment research all the time and I recently found three interesting papers that tested stop-loss strategies with very interesting results.
But before I get to how you can use the information to increase your returns first some detail on the research studies.


 

Research study 1 - When Do Stop-Loss Rules Stop Losses?

The first research paper I found is called When Do Stop-Loss Rules Stop Losses? and was published in May 2008 by Kathryn M. Kaminski and Andrew W. Lo.

The paper looked at the application of a simple stop-loss strategy applied to an arbitrary portfolio strategy in the US markets over the 54 period year period January 1950 to December 2004.

 

How applied

The strategy used a simple 10% stop loss value when exceeded the portfolio was sold and the cash invested in long term US government bonds. Investment would be moved back into the stock market once the 10% fall in the stock market was recovered (the 10% stop-loss was recovered).

 

What they found it worked very well

If the researchers excluded the technology bubble (used data from Jan 1950 to Dec 1999) when their simple stop-loss model got back into the stock market too quickly, they found that when the model was invested in the stock market it provided a higher return than bonds 70% of the time, and during stopped-out periods (when the model was invested in bonds), the stock market provided a higher return only 30% of the time.

Even applied to the whole 54 year period the study found that this simple stop-loss strategy provided higher returns while at the same time limiting losses substantially.

What they also found was that the stop-out periods were relatively evenly spread over the 54 year period they tested. This shows you that the stop-loss was not just triggered by a small number of large market movements (crashes).

 

 

Research study 2 – Performance of stop-loss rules vs. buy and hold strategy

The second research paper was called Performance of stop-loss rules vs. buy and hold strategy, published in 2009 by Bergsveinn Snorrason and Garib Yusupov.

 

What they tested

They compared the performance of following a trailing and traditional stop-loss strategy to a buy and hold strategy on companies in the OMX Stockholm 30 Index over the 11 year period between January 1998 and April 2009.

Investments were made on the first trading day of a quarter (starting January 1998) and at the end of a quarter the proceeds were reinvested.

When a stop-loss limit was reached, the company was sold and the proceeds held in cash until the next quarter when it was reinvested.

They tested stop-loss levels from 5 to 55%. 

 

Trailing stop-loss results

The table below shows the results of the use of a trailing stop-loss strategy.

As you can see the highest average quarterly return (Mean = 1.71%) was obtained by trailing stop-loss with a 20% loss level limit. The highest cumulative return (Cumulative = 73.91%) was achieved at the 15% trailing stop-loss limit.

The only stop-loss level that delivered a worse result than the buy-and-hold (B-H) portfolio, with a negative average return of 0.12% and cumulative return of -8.14%, was from a trailing stop-loss strategy with 5% loss limit.

 

Returns from using a trailing stop-loss strategy

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In the following chart which shows the results of the trailing stop-loss strategy.

 

Trailing Stop-loss, equally-weighted portfolio performance

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The result of using a 15% and 20% loss levels give you about the same overall result with a 20% stop-loss level leading to higher returns most of the time.

 

Traditional stop-loss strategy

The following table shows you the results if you applied a traditional stop-loss strategy, which means that you would calculate the stop-loss from the purchase price.

Returns from using a traditional stop-loss strategy

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As you can see all traditional stop-loss levels from 5% to 55% would have given you better returns than the buy and hold (B-H) strategy.

The  highest  average  quarterly  return  (Mean = 1.47%)  was achieved at the 15% stop loss level and the highest cumulative results of 57.1% at the 10% stop-loss level closely followed by the15% stop-loss level at 53.31%.

The chart below shows you the results of the traditional stop-loss strategy for all tested stop-loss levels.

 

Traditional Stop-loss, equally-weighted portfolio performance

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In the chart you can see that the 15% loss level would have given you the best result over the largest part of the 11 year test period.

 

What is the best strategy?

So what is the better stop-loss strategy, you may be thinking?

To find out I deducted the results of the traditional stop-loss strategy from the trailing stop-loss strategy.

The results are summarised in the following table:

Trailing stop-loss minus Traditional stop-loss

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Trailing better than traditional

Only at the 5% and 10% loss levels did the traditional stop-loss perform better than the trailing stop-loss. At all other loss levels the trailing stop loss out performed, most notably at the 20% loss level where it performed 27.47% better over the 11 year period.

 

 

Research study 3 - Taming Momentum Crashes: A Simple Stop-loss Strategy

The third research study I looked at is called Taming Momentum Crashes: A Simple Stop-loss Strategy by Yufeng Han (University of Colorado), Guofu Zhou (Washington University) and Yingzi Zhu (Tsinghua University) and was published in August 2014.

 

What they looked at

The researchers applied a simple momentum strategy of buying the 10% of companies with the largest price increase the past six months and selling short the 10% of companies with the largest price decline the past six months.

Once the stop-loss was triggered on any day the company was either sold (Winners) or bought (Losers) to close the position. The proceeds were invested in the risk-free asset (T-bills) until the end of the month.

 

Tested for 85 years

They applied this strategy over the 85 year period from January 1926 to December 2011 to all US domestic companies listed on the NYSE, AMEX, and NASDAQ stock markets (excluding closed-end funds and real estate investment trusts).

 

Lower losses

At a stop-loss level of 10%, they found that the monthly losses of an equal weighted momentum strategy went down substantially from −49.79% to −11.34%.

For the value-weighted (by the last month-end market size) momentum strategy, the losses were reduced from −65.34% to −23.69% (to -14.85% if August 1932 is excluded).

 

Higher returns

Not only did the application of the simple stop loss strategy reduce losses it also increased returns.

The stop-loss strategy increased the average return of the original momentum strategy from 1.01% per month to 1.73% per month (a 71.3% increase), while reduces the standard deviation of returns from 6.07% per month to 4.67% (23% reduction).

This increased the Sharpe ratio (measure of risk adjusted return) of the stop-loss momentum strategy to 0.371, more than double the level of the original momentum strategy of 0.166.

 

Helps you avoid market crashes

The stop-loss momentum strategy also completely avoided the crash risks of the original momentum strategy as the following table convincingly shows.

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Note that if you followed a stop loss strategy you would have made a small profit when the momentum only strategy lost nearly 50% and 40%.

 

Do you hate price driven stop loss strategies?

Do you hate a price driven stop-loss system? If you do you are most likely a hard core value investor.

Here is something you may want to consider, a fundamental stop loss suggested by a friend and long-term subscriber to the screener.

You can read the whole article here: Ever thought of using a fundamental stop-loss?

 

 

Summary and conclusion - Stop-loss strategies work

This has been a rather long article to come to a very clear and simple conclusion: Stop-loss strategies work

As you have seen:

  • When applied to a 54 year period a simple stop-loss strategy provided higher returns while at the same time lowering losses substantially
  • A trailing stop loss is better than a traditional (loss from purchase price) stop-loss strategy
  • The best trailing stop-loss percentage to use is either 15% or 20%
  • If you use a pure momentum strategy a stop loss strategy can help you to completely avoid market crashes, and even earn you a small profit while the market loses 50%
  • Stop-loss strategies lowers wild down movements in the value of your portfolio, substantially increasing your risk adjusted returns

 

The difficult part

The key to making a stop-loss strategy work is to stick to the plan, not once but over and over and over again. The difficult part is to not let your emotion keep you from selling when a stop-loss level is reached.

 

How to implement your stop-loss strategy

This is how you can implement a stop-loss strategy in your portfolio, it is also the strategy we will be using in the newsletter.

  1. Implement a trailing stop-loss strategy where you calculate the losses from the maximum price the company has reached since you bought it
  2. Only look to see if the stop-loss percentage has been exceeded on a monthly basis. If you look at it on a daily basis you may sell the investment if the company share price gets volatile. This will also ensure that you keep your trading costs as low as possible
  3. Sell your investment if at the monthly evaluation date the trailing stop-loss level of 20% has been exceeded
  4. Measure the trailing stop-loss in the currency of the company’s primary listing. This means measure the stop-loss of a Swiss company in Swiss Francs (CHF) even if your portfolio currency is Euros
  5. Reinvest the cash from the sale in the best idea that currently fits with your investment strategy. If you subscribe to the newsletter you would invest in the ideas you receive the month the investment is sold

 

Of course it will not always work

These studies all showed the success of a stop-loss strategy over long periods of time, this of course does not mean that a buy and hold strategy will not sometimes outperform your stop-loss strategy but over the long term it will reduce your portfolio’s volatility (large losses) and increase your compound investment returns.

 

System that sells your losers to invest in your best ideas

What a stop loss strategy also does is gives you a system to sell losing investments and invest the proceeds in your current best idea which may be a large potential winner.

 

Your stop-loss analyst

 

Tim_sign3

PS Do you hate a price driven stop-loss system? If so here is an idea that will help you limit your losses if the underlying business of your investment starts to go downhill. Ever thought of using a fundamental stop-loss?

 

Sources:

Performance of stop-loss rules vs. buy and hold strategy Bergsveinn Snorrason and Garib Yusupov – Spring 2009

Taming Momentum Crashes: A Simple Stop-loss Strategy Yufeng Han, Guofu Zhou, Yingzi Zhu, August, 2014

When Do Stop-Loss Rules Stop Losses? Kathryn M. Kaminski and Andrew W. Lo May 1st, 2008

The Big Picture Blog - The Virtues of Stop Losses