[ed. note: If you’ve read my work here at Stock Gumshoe over the past many years, you probably know that I don’t use strict or consistent stop losses with my holdings and I tend not to like the practice — but I thought you’d like to hear the other side, why they can work and how they work, so I asked Tim du Toit, a longtime European reader who has written about both value investing and quantitative investing, to share the results of his research. He’s also got an interesting stock idea for you at the end… enjoy!]
We here at Quant Investing have never been strong supporters of stop-loss systems. This is mainly because testing we did came to the conclusion that a stop-loss strategy leads to lower returns even though it reduced volatility (large losses).
Why we read all the time?
However, we recently found three interesting papers that tested stop-loss strategies with very interesting results.
Before I get to how you can use the information to increase your returns, some detail on the research studies:
Research study 1 – When Do Stop-Loss Rules Stop Losses?
The first research paper I found is called When Do Stop-Loss Rules Stop Losses? and was published in May 2008 by Kathryn M. Kaminski and Andrew W. Lo.
The paper looked at the application of a simple stop-loss strategy applied to an arbitrary portfolio strategy in the US markets over the 54 period year period January 1950 to December 2004.
The strategy used a simple 10% stop loss value — when exceeded, the portfolio was sold and the cash invested in long term US government bonds. The investment would be moved back into the stock market once the 10% fall in the stock market was recovered (the 10% stop-loss was recovered).
What they found: it worked very well
If the researchers excluded the technology bubble (used data from Jan 1950 to Dec 1999), when their simple stop-loss model got back into the stock market too quickly, they found that when the model was invested in the stock market it provided a 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 only 30% of the time.
Even applied to 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.
What they also found was that the stop-out periods were relatively evenly spread over the 54 year period they tested. This shows you that the stop-loss was not just triggered by a small number of large market movements (crashes).
"reveal" emails? If not,
just click here...
Research study 2 – Performance of stop-loss rules vs. buy and hold strategy
The second research paper was called Performance of stop-loss rules vs. buy and hold strategy, published in 2009 by Bergsveinn Snorrason and Garib Yusupov.
What they tested
They compared the performance of following a trailing and traditional stop-loss strategy to a buy and hold strategy on companies in the OMX Stockholm 30 Index over the 11 year period between January 1998 and April 2009.
Investments were made on the first trading day of a quarter (starting January 1998), and at the end of a quarter the proceeds were reinvested.
When a stop-loss limit was reached, the company was sold and the proceeds held in cash until the next quarter when it was reinvested.
They tested stop-loss levels from 5 to 55%.
Trailing stop-loss results
The table below shows the results of the use of a trailing stop-loss strategy.
As you can see the highest average quarterly return (Mean = 1.71%) was obtained by trailing stop-loss with a 20% loss level limit. The highest cumulative return (Cumulative = 73.91%) was achieved at the 15% trailing stop-loss limit.
The only stop-loss level that delivered a worse result than the buy-and-hold (B-H) portfolio, with a negative average return of 0.12% and cumulative return of -8.14%, was from a trailing stop-loss strategy with 5% loss limit.
Returns from using a trailing stop-loss strategy
Trailing Stop-loss, equally-weighted portfolio performance
The result of using a 15% and 20% loss levels give you about the same overall result with a 20% stop-loss level leading to higher returns most of the time.
Traditional stop-loss strategy
The following table shows you the results if you applied a traditional stop-loss strategy, which means that you would calculate the stop-loss from the purchase price.
Returns from using a traditional stop-loss strategy
As you can see all traditional stop-loss levels from 5% to 55% would have 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 and the highest cumulative results of 57.1% at the 10% stop-loss level closely followed by the15% stop-loss level at 53.31%.
The chart below shows you the results of the traditional stop-loss strategy for all tested stop-loss levels.
What is the best strategy?
So what is the better stop-loss strategy, you may be thinking?
To find out I deducted the results of the traditional stop-loss strategy from the trailing stop-loss strategy.
The results are summarised in the following table:
Trailing better than traditional
Only at the 5% and 10% loss levels did the traditional stop-loss perform better than the trailing stop-loss. At all other loss levels the trailing stop loss out performed, most notably at the 20% loss level where it performed 27.47% better over the 11 year period.
Research study 3 – Taming Momentum Crashes: A Simple Stop-loss Strategy
The third research study I looked at is called Taming Momentum Crashes: A Simple Stop-loss Strategy by Yufeng Han (University of Colorado), Guofu Zhou (Washington University) and Yingzi Zhu (Tsinghua University) and was published in August 2014.
What they looked at
The researchers applied a simple momentum strategy of buying the 10% of companies with the largest price increase the past six months and selling short the 10% of companies with the largest price decline the past six months.
Once the stop-loss was triggered on any day the company was either sold (Winners) or bought (Losers) to close the position. The proceeds were invested in the risk-free asset (T-bills) until the end of the month.
Tested for 85 years
They applied this strategy over the 85 year period from January 1926 to December 2011 to all US domestic companies listed on the NYSE, AMEX, and NASDAQ stock markets (excluding closed-end funds and real estate investment trusts).
At a stop-loss level of 10%, they found that the monthly losses of an equal weighted momentum strategy went down substantially from −49.79% to −11.34%.
For the value-weighted (by the last month-end market size) momentum strategy, the losses were reduced from −65.34% to −23.69% (to -14.85% if August 1932 is excluded).
Not only did the application of the simple stop loss strategy reduce losses, it also increased returns.
The stop-loss strategy increased the average return of the original momentum strategy from 1.01% per month to 1.73% per month (a 71.3% increase), while reduces the standard deviation of returns from 6.07% per month to 4.67% (23% reduction).
This increased the Sharpe ratio (measure of risk adjusted return) of the stop-loss momentum strategy to 0.371, more than double the level of the original momentum strategy of 0.166.
Note that if you followed a stop loss strategy you would have made a small profit when the momentum only strategy lost nearly 50% and 40%.
Summary and conclusion – Stop-loss strategies work
This has been a rather long article to come to a very clear and simple conclusion: Stop-loss strategies work
As you have seen:
- When applied to a 54 year period a simple stop-loss strategy provided higher returns while at the same time lowering losses substantially
- A trailing stop loss is better than a traditional (loss from purchase price) stop-loss strategy
- The best trailing stop-loss percentage to use is either 15% or 20%
- If you use a pure momentum strategy a stop loss strategy can help you to completely avoid market crashes, and even earn you a small profit while the market loses 50%
- Stop-loss strategies lowers wild down movements in the value of your portfolio, substantially increasing your risk adjusted returns
The difficult part
The key to making a stop-loss strategy work is to stick to the plan, not once but over and over and over again. The difficult part is to not let your emotion keep you from selling when a stop-loss level is reached.
How to implement your stop-loss strategy
This is how you can implement a stop-loss strategy in your portfolio, it is also the strategy we use for the newsletter.
- Implement a trailing stop-loss strategy where you calculate the losses from the maximum price the company has reached since you bought it
- Only look to see if the stop-loss percentage has been exceeded on a monthly basis. If you look at it on a daily basis you may sell the investment if the company share price gets volatile. This will also ensure that you keep your trading costs as low as possible
- Sell your investment if at the monthly evaluation date the trailing stop-loss level of 20% has been exceeded
- Measure the trailing stop-loss in the currency of the company’s primary listing. This means measure the stop-loss of a Swiss company in Swiss Francs (CHF) even if your portfolio currency is Euros
- Reinvest the cash from the sale in the best idea that currently fits with your investment strategy. If you subscribe to the newsletter you would invest in the ideas you receive the month the investment is sold
Of course, it will not always work
These studies all showed the success of a stop-loss strategy over long periods of time, this of course does not mean that a buy and hold strategy will not sometimes outperform your stop-loss strategy… but over the long term it will reduce your portfolio’s volatility (large losses) and increase your compound investment returns.
System that sells your losers to invest in your best ideas
What a stop loss strategy also does is gives you a system to sell losing investments and invest the proceeds in your current best idea which may be a large potential winner.
Your stop-loss analyst
Tim du Toit
Performance of stop-loss rules vs. buy and hold strategy Bergsveinn Snorrason and Garib Yusupov – Spring 2009
Taming Momentum Crashes: A Simple Stop-loss Strategy Yufeng Han, Guofu Zhou, Yingzi Zhu, August, 2014
When Do Stop-Loss Rules Stop Losses? Kathryn M. Kaminski and Andrew W. Lo May 1st, 2008
The Big Picture Blog – The Virtues of Stop Losses
Interesting investment idea
Here is an interesting investment idea the screener (www.quant-investing.com/screener) came up with for you to research further.
In spite of its fast growth the company is cheap because it has a bit of Greek flavour.
The company is called Globo PLC and is listed on the London AIM market (GBO.L, GOBPY OTC in the US).
It’s a smartphone app developer and its growing fast.
For the year ended 31 December 2014, the company reported a 48.8% increase in sales to €106.4 million from €71.5 million, the previous year. The increase was primarily driven by a strong organic growth in the mobile products and services of the company, where sales grew 49.0% to €96.4 million from €64.7 million.
Globo Technologies S.A., its associate company in Greece, saw a 27.8% increase in sales to €32.2 million and contributed to 30.2% of the overall sales.
Operating profit amounted to €37.3 million, up by 36.6% from the previous year. Operating profit increased less than sales due to increased distribution and administration expenses.
Net profit increased by 38.2% to €35.0 million from €25.3 million, while earnings per share increased 27.0% to €0.094 from €0.074.
At the current share price of GBP 0,575 the company is valued at only 8.9 times trailing 12 months earnings
(Note: the share price is quoted in GBP but the results are published in Euro)
Disclosure: I have a position in Globo PLC and will not buy or sell any shares for three days after this article has been published.
This is a discussion topic or guest posting submitted by a Stock Gumshoe reader. The content has not been edited or reviewed by Stock Gumshoe, and any opinions expressed are those of the author alone.