Stop-Loss Effectiveness

From Falkenblog:

I’m sure everyone has been presented with the following logic: put in a ‘stop-loss’ at some arbitrary amount, say losing 1%. Then, your payoff distribution is tilted towards infinity, as shown above. It’s like the idea of going to Vegas, and saying you will stop when you lose $500, so you think that you still have an equal chance of generating those +$500 and up numbers, and the bad outcomes are just truncated at -$500. Alas, it doesn’t work like the graphs above. Instead, it generates the graph below, with a lot of probability mass at the stop-loss point:

From a nice little paper by Detko, Ma and Morito (2008).

Talk to Frank about Stop-Losses

  • Walter

    I think “cutting your losses” works in general though, because there is momentum in the markets. A blind strategy of cutting losses and letting winners run will take advantage of momentum and has historically produced good returns. In contrast, a strategy of buying losers and selling winners performs very badly.

    I think this is important to keep in mind, even (or, especially) for value investors. One of the hardest skills to master, I believe, is learning to be selective about where you place your convictions, and cutting your losses all other times.

  • Walter

    Well, either that or, being extremely selective about making investments in the first place. If you are able to do that, it’s definitely preferable, but I know that I get excited too easily and make investments that I regret later. In that case, you cannot let your prior decision to buy a stock, a decision you would not repeat at the current lower price but deteriorated fundamental situation, influence your current portfolio.

  • Riteshsrivastava81

    Well i feel stp Vs Tp is equal to 1: 3

    • Anonymous

      Hi Ritesh – can you elaborate?

      Frank Voisin