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If I remember this correctly, research indicates that if the portfolio is being driven by a random walk process, a stop-loss always causes a reduction in return
by vijucat 10y ago
If I remember this correctly, research indicates that if the portfolio is being driven by a random walk process, a stop-loss always causes a reduction in returns (negative stopping premium), i.e., stop-losses are useful only if the return generating process can be shown to not be a random walk.
Also, they tend to mess with your mind (loss-aversion psychology, deep feeling of pain at losses) and make you exit and enter the trade multiple times, adding up to transaction costs, too.
All in all, a) Buy and Hold may actually be quite sensible and b) stop-losses are actually much more complicated than you'd think and seem to be a mathematical rabbit hole.
Stop-losses may make sense in, say, an intraday pair-trading strategy where an analysis of past return evolution clearly shows that winners keep winning and losers are hopeless beyond a point.
- mrchicity 10y agoExactly. Unless you can show that the price continues to move against your losing positions by more than their cost to liquidate, you shouldn't do it. Your screw-up was putting the bad trade on in the first place. I'm especially surprised it's used in a model like this. Most quant funds use some type of portfolio risk management to allocate capital toward bets that with the highest expected return while controlling overall risk. That losing stock may be offsetting other risks in the portfolio. As I mentioned in my other comment, a stop-loss is a very crude approach to risk management. It will help control the middle of your left tail, but the far left tail extreme events cannot be protected against by such a rule.