When Does It Really Pay To Use Stop Losses?

by: Stockopedia

The subject of stop losses provokes heated discussion here on Stockopedia. Opinions are divided on how, why, when, where and if you should set a pre-defined exit price on a trade. Some investors won't use stop losses, but others can't live without them.

One of the biggest questions about stop losses is why they should even be used in the first place. Those in favour point to the benefits of lower volatility in a portfolio and protection from sudden single-stock disasters. For that reason, they're often promoted by traders like Robbie Burns and Mark Minervini.

But the counter-argument is that a regular buy-and-hold strategy (without stops) will even itself out over time. Without a stop, you won't be at risk of being shaken out of a position. You won't be left wondering what to do if you're stopped out. You won't be hit by extra trading costs. And you won't be at risk of missing a recovery.

The arguments on both sides are persuasive. So, in the coming weeks, we're going to be looking a little closer at stop losses and exploring some of the science and behaviour behind them.

To start with, I'm going to look at research into whether stop-loss strategies are superior to buy-and-hold. Spoiler alert: Don't expect all the answers. I discovered that even one of the leading authorities on the subject believes there are always trade-offs between the two!

Why there are two sides to stop losses

To begin with, it's worth thinking about the nature of stop losses and how they're used. Arguably, many see them as just a risk management tool for cutting losses if prices tumble. That's perfectly reasonable, but there's a problem here. The decision to sell often isn't balanced by a pre-planned strategy for buying back in again. Ignoring this second part means not having a plan for staying invested in equities as much as possible.

The question of when to sell and when to buy back was the focus of a study by Joachim Klement, who is currently head of thematic research at the investment bank Credit Suisse. In 2013, he endeavoured to figure out when stop losses worked best using global market data spanning 1970-2013. He started with the following set of possible tactics:

1. Fast out / fast in (three months / three months): In other words, sell the asset if the cumulative loss over the past three months exceeds a pre-planned threshold (i.e., the stop loss) and re-enter the asset if the cumulative gain over the past three months exceeds another threshold.

And then, the following variations:

2. Fast out / slow in (three months / twelve months).

3. Slow out / fast in (twelve months / three months).

4. Slow out / slow in (twelve months / twelve months).

Klement's extensive study looked carefully at how the different stop-loss strategies performed in bull and bear markets. He also examined the importance of where the stop loss was set, using standard deviation as his measure (a subject for another article).

The results? He found that the main benefit of stop-loss strategies is a reduction in volatility and drawdowns. This makes them particularly desirable for investors who are loss-averse. However, the findings also showed that stops can increase returns "if these rules are set intelligently".

The fast-out strategies, using 3-month cumulative returns, were better at closing out of positions when there was a sudden, severe crash. But the fast-out / fast-in strategy was damaging to returns because it incurred high trading costs.

By contrast, the slow-out strategies tended not to trigger stops during price crashes. The slow-in / slow-out strategy also left the investor out of the market for too long, missing the benefits of a recovery. But while these slow-out downsides seem contrary to why investors actually use stop losses, it was actually the slow-out / fast-in strategy that produced the best absolute and risk-adjusted returns.

Klement found there was no single rule of thumb for where to set stop-loss and re-entry points for different types of asset across different geographies. However, the returns for the slow-out / fast-in strategy were achieved with rules using the asset's volatility - "with stop-loss thresholds around 0.5 annual standard deviations and a re-entry threshold around 0.25 annual standard deviations".

What this means for individual investors

Klement's study review of the evidence led to the conclusion that different strategies worked better in different market conditions. But in practice, that doesn't really make things any clearer for investors.

Agonising over this, I contacted Klement to try and understand how his research translates to the real world. He agreed that there are two problems with the theory that the stop-loss strategy should change depending on the overall market circumstances:

"First, it requires one to know if one is in a secular bull or bear market, and this is very hard to do in real time. And second, it makes the stop loss rule even more complex, and hence, harder for private investors to follow. I usually stick to the slow-out / fast-in rule with my clients all the time."

Klement also said that stop losses should be applied on a stock by stock basis, because behavioural finance shows that investors too often don't think in portfolio terms but in single investments. He said:

"Even if the overall portfolio is doing well, a single stock with a bad performance can ruin the mood and induce the investor to make mistakes. So, I suggest applying the stop loss rule to every single stock."

Klement added that what a stop loss rule applied to single stocks does is effectively the following: it gradually reduces the number of stocks in a portfolio as a bull market matures and turns into a bear market. And it gradually increases the number of stocks in a portfolio as a bear market matures and stocks recover.

What's the upshot of all this?

Klement's research is important because he took a very deep dive into the data to understand when stops work and when they don't. Equally, he pressed the importance that stop-loss strategies should include a pre-set decision of when to sell and when to buy back in again.

Overall, the findings reinforce the view that stops reduce volatility and drawdowns. But they can come at the cost of extra trading fees, less time in the market and the potential of missing a recovery. Understandably, some see it as a price worth paying.

Technically, using certain rules, stops can enhance returns - but not necessarily in the way you might think. Slow-out / fast-in stop-loss rules don't offer much protection from sudden, severe price crashes. That's despite the fact that this kind of gut-wrenching disaster is the reason why most investors use stop losses. What that rule does, instead, is keep the investor in the market during upward trends, even if there are intermittent crashes. It only starts to sell positions when the market is rolling over and a bear phase is established. According to this research, it's the superior approach.

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