Academic journal article Financial Services Review

The Value of Stop Loss Strategies

Academic journal article Financial Services Review

The Value of Stop Loss Strategies

Article excerpt

Abstract

Stop loss strategies can prevent investors from holding their losing investments too long by automatically prompting the sales of losing investments. We examine the impacts of stop loss strategies on the return and risk of individual common stocks. Our results indicate that these strategies neither reduce nor increase investors' losses relative to a buy-and-hold strategy once we extend security returns from past realizations to possible future paths. One unique stop loss mechanism, nevertheless, helps investors to reduce investment risk. These findings suggest that the value of stop loss strategies may come largely from risk reduction rather than return improvement.

© 2009 Academy of Financial Services. All rights reserved.

JEL classification: C15; G11

Keywords: Disposition effect; Bootstrapping; Simulation

1. Introduction

Investors tend to hold their losing investments too long and sell their winning investments too soon (i.e., the disposition effect; see Kahneman and Tversky, 1979; Shefrin and Statman, 1985; Odean, 1998). Shefrin and Statman (1985) suggest that this tendency arises from behavioral biases such as mental accounting, pride seeking, regret avoidance, and the lack of self-control. One possible remedy for this behavioral tendency is to use stop loss strategies that prompt the sales of losing investments. A stop loss strategy allows an investor to specify a condition under which a losing investment is automatically sold. Because investors do not have to make contemporaneous selling decisions, stop loss strategies can possibly prevent the behavioral biases and help investors to realize their losses sooner. Stop loss strategies are also touted in practice to improve investment returns.

Stop loss strategies, on the other hand, may not be efficient. If security returns are predictable, stop loss strategies fail to incorporate relevant information from the time a strategy is set to the time the contingent sell order is executed. When security returns are unpredictable, selling a losing investment before the end of a holding period does not guarantee that an investor will be better off at the end of this holding period. Although the investor will not incur any further loss on the specific investment, he also gives up the opportunity that this investment may recover during the rest of his holding period. Gollier (1997) and Dybvig (1988) also shows that stop loss strategies are inefficient relative to other possible dominating strategies.

In this article we examine the impacts of stop loss strategies on the return and risk of individual common stocks. In particular, we investigate whether investors using stop loss strategies to sell their (losing) investments would be better off relative to a buy-and-hold strategy. We consider two stop loss strategies on ordinary common stocks listed on the New York Stock Exchange (NYSE) and the American Stock Exchange (AMEX) from 1970 to 2005. Under a stop loss strategy, an investor holds the underlying stock until the specified stop loss condition is met. The investor then reinvests his proceeds in either the S&P 500 index (the SP strategy) or the risk-free asset (one-month T-BiIl; the RF strategy) until the end of his holding period. Under the buy-and-hold strategy (the BH strategy), the investor holds the underlying stock for the entire holding period. We examine the holding periods of three months, six months, and one year. We also consider two alternative stop loss mechanisms: The traditional stop loss with a fixed stop price, and the trailing stop loss with a stop price that adjusts upwards automatically with the security price but not downwards.

Using historical return paths and random starting dates for a given holding period, the results show that stop loss strategies can indeed reduce investors' effective holding periods on losing investments. Traditional stop loss strategies have been able to reduce investors' losses on certain stocks but not the others. …

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