Investors are often told to "cut your losers and run your winners". It makes a lot of sense. Many studies show that stocks, both individually and collectively, exhibit positive momentum. This means stocks that rise in price are more likely to keep rising, and vice versa, especially in the short term.
Indeed, Frank Fabozzi of Yale University found that a strategy of buying the best-performing shares and selling the worst generated average excess returns of 1.3% a month between 1995 and 2003. But running winners and cutting losers particularly the latter is easier said than done. We tend to be too keen to take profits, and too reluctant to crystallise losses. One way to get around this is by using stop-losses setting a price at a point below your buying price at which you will automatically sell up and take your losses. But does it work? And where should you set your stops?
The evidence is mixed. In a 2009 study, Adam Lei of Midwestern State University found evidence that some (though not all) stop-loss strategies could improve the risk/reward trade-off by reducing volatility. Credit Suisse's Joachim Klement (now at the CFA Institute) finds a similar result for most major global share markets (but not for gold or commodities). Fund manager Lee Freeman-Shor of Old Mutual tracked the fate of 131 stocks bought by managers he followed that fell by 40%.
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Of those, none made it back to break-even point. That suggests there's a fairly definitive point at which you should give up hope. Yet setting stop-losses too tightly can be counterproductive. Freeman-Shor found that in 60% of cases, fund managers who sold shares after modest falls of up to 10% ended up regretting it missing out on a subsequent rally.
There's also the problem that over the long run shares start to exhibit negative momentum. Those that have fallen the hardest are more likely subsequently to rise. Indeed, Werner De Bondt and Richard Thaler found that portfolios of the worst-performing stocks over the past 12 months tended eventually to beat those that had previously done well.
Antonios Antoniou of the University of Durham found a similar effect for London stocks between 1985 and 2000. This means that those who have overly tight stops may find themselves forced to take losses (or stopped out) only to be left out when their former shares recover.
Still, even if they may not directly boost returns, stop-losses have their uses. Automatically closing out any investment that falls by a predetermined amount (say 25%) from the initial purchase price prevents you holding a share because you're too lazy to sell it. Even if you're convinced it's a good investment, being forced to consider making a conscious decision to reinvest in it may make you reassess why you bought it to begin with.
Matthew graduated from the University of Durham in 2004; he then gained an MSc, followed by a PhD at the London School of Economics.
He has previously written for a wide range of publications, including the Guardian and the Economist, and also helped to run a newsletter on terrorism. He has spent time at Lehman Brothers, Citigroup and the consultancy Lombard Street Research.
Matthew is the author of Superinvestors: Lessons from the greatest investors in history, published by Harriman House, which has been translated into several languages. His second book, Investing Explained: The Accessible Guide to Building an Investment Portfolio, is published by Kogan Page.
As senior writer, he writes the shares and politics & economics pages, as well as weekly Blowing It and Great Frauds in History columns He also writes a fortnightly reviews page and trading tips, as well as regular cover stories and multi-page investment focus features.
Follow Matthew on Twitter: @DrMatthewPartri
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