Truths about stop-losses – A stop-loss strategy for the newsletter

You know I have not been a great supporter of following a stop-loss strategy.

This is mainly because previous testing we did brought us to the conclusion that a stop-loss strategy leads to lower returns, even though it did reduce volatility (large price movements up or down).

Why we read all the time?

But you know we look at investment research all the time and I recently found three papers that tested stop-loss strategies with very interesting results.

Before I get to how you can use the information to increase your investment returns (and the returns of the newsletter) first let me give you some details 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 market over a 54 year period from January 1950 to December 2004.

They found it worked very well

If the researchers excluded the technology bubble (only using data from January 1950 to December 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 an 11-year period between January 1998 and April 2009.

What is the best strategy?

Both the trailing (except at the 5% level) and traditional stop-loss systems did better than the buy and hold strategy.

If you compare the trailing and traditional stop-loss systems, it was only at the 5% and 10% loss levels that the traditional stop-loss performed better than the trailing stop-loss system.

At all other loss levels the trailing stop-loss strategy 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 was 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 in the past six months and selling short the 10% of companies with the largest price decline in 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 risk-free assets (T-bills) until the end of the month.

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%.

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 it reduced the standard deviation of returns from 6.07% to 4.67% per month (a 23% reduction).

Let’s you avoid market crashes

The stop-loss momentum strategy also completely avoided the crash risks of the original momentum strategy.

This is important as we use momentum when selecting ideas for the newsletter.

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 .

That is why, from this month, we are implementing a stop-loss system for the newsletter, and here is how we are going to do it.

Implementing a stop-loss system for the newsletter

1. A trailing stop-loss system 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 share price becomes 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. Adjust the trailing stop-loss for dividend payments when the share price usually declines the same as the dividend payment.
6. Reinvest the cash from the sale in a current newsletter investment idea. This will make sure that you sell losing investments and invest the proceeds in the current best ideas.

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 emotions keep you from selling when a stop-loss level is reached.

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 that over the long term it will definitely reduce your portfolio’s volatility (large losses) and increase your compound investment returns.