By Joachim Klement, CFA
In my previous career I was a theoretical physicist.
I was a different person then. For those who know the television show The Big Bang Theory, the best way to describe my personality back then is that I was a real-life Sheldon Cooper.
My first job in the investment industry was as a quantitative research analyst. It suited me well because I was enamored of quantitative models.
I vividly remember one of my first assignments in the research department of a major bank. There was a never-ending discussion as to whether or not we should use stop losses to manage our recommendations. One group argued that stop losses protected clients from excessive losses. The other faction contended that long-term investors should avoid stop losses because, first, you could be stopped out of the market at the worst possible time, and second, there is no fixed rule as to when to re-enter the market.
Unable to reach a consensus, they made the fateful decision to pass the buck to the junior analyst and let me do the hard work to settle the argument. The results were quite clear: Stop losses do not systematically enhance performance or risk-adjusted returns.
It all depends on the stop-loss rule used, the asset class, and whether there's a bear or bull market.
I encountered the stop-loss conundrum many times since those early days, so I decided to write down my collected wisdom in an article for The Journal of Trading.
The Difference between Theory and Practice
My view on stop losses changed when I became more involved in real-life money management and began dealing directly with clients. Today, I admit that I have learned to love stop losses.
There's a helpful quote, variously attributed to Einstein, Yogi Berra, and the Dutch computer scientist Jan L. A. van de Snepscheut: "In theory, there is no difference between theory and practice. In practice, there is."
That is the lesson stop losses taught me. Once involved in investment management, I had both individual as well as sophisticated institutional investors as clients. Yet no matter their level of sophistication and investment knowledge, when markets declined significantly, they all worried about their portfolio losses. Worries turned into complaints, and if the losses grew too big or weren't recovered fast enough, those complaints turned into asset outflows.
Not even sophisticated investors can handle long periods of negative performance or underperformance relative to a benchmark. Need proof? GMO has lost about a third of its assets after missing the recent stock market rally - and this despite calling the last two major market tops in 2000 and 2008.
Stop losses may not enhance returns, but they enhance client well-being, and in the end, they may keep a client from selling what is otherwise a great long-term investment.
I prefer a suboptimal portfolio and a client rather than an optimal portfolio and no client. By using stop-losses I might incur additional trading costs, but I also reduce drawdowns in my portfolios.
And with lower drawdowns, clients are less anxious and less likely to fire me.
Getting Back in the Saddle
Of course, the question is how to re-enter the market once an investment has been sold. As a money manager, being stopped out of an investment provides the opportunity to reassess the investment case without the potentially harmful influence of the "endowment effect."
What is the endowment effect? It's the tendency to ascribe a higher value - or higher returns - to assets we already own compared to investments that we don't. If we own an investment, we often overemphasize its potential benefits while ignoring or downplaying its potential risks.
If a stop loss has been triggered and a cooling-off period has passed, the endowment effect is less likely to influence our analysis of an investment and we might see it in a different light. Of course, it could well be that the fundamental case for the investment hasn't changed. Then the question becomes whether to enter into it again.
Here we might look to changes in momentum for clues. Once price momentum becomes positive, it is time to invest again.
Alternatively, we can employ inverse stop losses - clearly defined price levels that trigger a purchase if the investment rises above this level.
Both of these techniques have helped increase behavioral alpha for both my clients and myself.