You hate Stop-Losses, don’t you?
Everyone does it.
In particular, the hardcore value investors following Waffet’s credo. Warren Buffett has mentioned several times that he does not care what happens to a company’s share price as long as the fundamentals of the business are doing well.
Fine! But… What if you – a poor individual investor with limited time and capacity – realize late that the company is doing bad, actually after wondering why the shares are plunging?
I admit that I did hate stop-losses in the past and still today when they are triggered just before a rebound.
But, in fact, there are some behavioural reasons why an automated Stop-Loss seems to be a good idea.
- Cutting sunk costs on time: We know that one of the most common mistakes that humans make in life is not cutting sunk costs on time. Humans and investors try to justify our decisions, we are not able to assess them objectively, and as a result, we end up dumping time, money and effort in already failed endeavours. In investing, this bias is also known as disposition effect.
- Pain killers: Losses hurt us twice as much as the profits’ satisfaction. “Losses loom larger than gains”. So, if something is hurting us, let’s take a pain killer.
Research
However, there is also some research that speaks in favour of the Stop-Losses.
1 – When Do Stop-Loss Rules Stop Losses? (Kathryn M. Kaminski & Andrew W. Lo., 2008)
The paper looked at the application of a simple stop-loss strategy applied to an arbitrary portfolio strategy (for example buying the index) in the US markets over the 54 year period from January 1950 to December 2004.
The strategy used a simple 10% stop loss rule. When a 10% loss was exceeded the portfolio was sold and the cash invested in long term US government bonds. Cash would be moved back into the stock market once the 10% fall in the stock market was recovered (the 10% stop-loss was recovered).
The researchers found that when the model was invested in the stock market it gave 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 than bonds only 30% of the time.
So it worked. Over 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.
2 – Performance of stop-loss rules vs. buy and hold strategy (Bergsveinn Snorrason & Garib Yusupov, 2009)
The paper compares the performance of following a trailing (TSL) and normal stop-loss (SL) strategy to a buy and hold (B-H) strategy on companies in the OMX Stockholm 30 Index over the 11 year period between January 1998 and April 2009. This is a short test period but it included the bursting of the internet and the financial crisis. Investments were made on the first trading day of every quarter (starting January 1998). When a stop-loss limit was reached, the stocks were sold and cash was held until the next quarter when it was reinvested. What is really helpful is they tested stop-loss levels from 5% to 55%.
Trailing stop-loss
A Trailing stop-loss gets calculated as a percentage of drawdown from the maximum price reached since the acquisition date.
$$TSL=DD*max(P_0,.._T)$$
The table below shows the results of the use of a trailing stop-loss strategy.
As you can see (page 28) the highest average quarterly return (Mean = 1.71%) was obtained with a 20% trailing stop-loss level limit. The only stop-loss level that did worse than the buy-and-hold (B-H) portfolio was from a trailing stop-loss strategy with 5% loss limit. Of course, this makes sense as 5% is too tight for long-term investors.
Traditional stop-loss strategy – not trailing
The authors checked as well the results applying a traditional stop-loss strategy, which means that you would calculate the stop-loss from the purchase price.
$$SL=DD*P_0$$
As you can see (page 30) all traditional stop-loss levels from 5% to 55% would have also 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.
3 – Stock market investors’ use of stop losses and the disposition effect (Daniel W. Richards & all, 2017)
This paper shows that stop-loss strategies used as part of investment decisions are an effective tool for inoculating against the disposition effect.
Using data from UK investors from 2009 -2016, they try to validate some hypothesis around the disposition effect. The authors don’t pretend to compare the performance of different strategies, rather confirm that automatic tools like stop-losses act as a “nudge” and actually help investors to get rid of the losing stocks while holding the winners longer.
Conclusions
- Stop-Losses help human-like investors to overcome behavioural biases.
- Some studies have shown that almost all stop-loss strategies outperform the B-H strategy.
- Among the Stop-loss strategies, the better is the trailing stop-loss (TSL) at the 20% drawdown level.
In Summary, for all those who are like me, lazy and undisciplined guys who don’t follow the stock market on a daily basis and get insomnia when the markets are heading south, definitely, Stop-Losses should be your best friends, a must.
Stop-Losses in the RQM strategy
In the RQM strategy, we apply a stop-loss in two steps.
If Profits <20%, we set a Stop-loss at 15% of the Acquisition Price.
If Profits > 20%, we set a Trailing Stop-Loss at 20%.
The stop-loss is recalculated on a monthly basis, the first weekend of the month. If during this month the Stop-Loss gets triggered, the position is sold and converted into cash. The Stop-Loss is always calculated in local currency.
The cash generated is only reinvested next month, following strickly the RQM stock selection method.
In the end, what we are looking for is a system that gives us the discipline to sell losing investments and reinvest them in the best stocks at the moment.
