As long time readers know I am a big supporter of stop losses.
I use them not just to limit losses but also to let my winning investments run and not sell too quickly – a trailing stop loss
One problem with stop losses is that there are not many analytical studies that have tested their effectiveness over long periods of time.
One of the reasons is its very difficult to back test investment strategies while also factoring in stop losses.
Just think about it.
Normal back tested investment studies looks at fundamental data once a year and builds a portfolio. It then looks at the portfolio a year later. Calculates the results of the sale of all holdings, builds a new portfolio and looks at it a year later and so on.
If the study factored in stop losses the researcher had to check daily, weekly or monthly if the stop loss was reached and then remove the company from the portfolio. Now the researcher must update his selection criteria to replace the sold investment. It can be done immediately, at the end of the week, month or year. But I am sure you will agree it’s a lot more work.
I have been looking around for studies on the use of stop losses and have come across this article written by Kevin Lane a founding partner of Fusion Analytics, and is the firm’s director of Quantitative Research called The Virtues of Stop Losses
Here is an extract:
“The moral of this story is not that stops are the end all be all, but rather if you methodically and mechanically stick to your discipline your results will be smoother and with less volatility and you won’t let any bad investments get too bad!”
The whole article is really worth a few minutes of your time.
The use of stop losses are controversial as the comments in this article Do you know the first rule of investing? shows