The value of stop-loss, stop-gain strategies in dynamic asset allocation

Abstract

Dynamic asset allocation strategies which utilize stop-loss and stop-gain rules may dramatically decrease risk and even increase long-term return relative to other traditional asset allocation strategies. I introduce a dynamic asset allocation strategy which shifts portfolio weights based on predefined stop-loss and stop-gain rules. The two-asset (S&P mutual fund and bond mutual fund) strategy tested from 1990 to 2012 produces an annual geometric return of 8.45% vs. 7.50% for the underlying S&P 500 Index fund with 50% less volatility (9.41% vs. 18.76% for the S&P index fund). In addition, the strategy displays a positive and significant CAPM alpha over the sample period. The strategy’s very strong results are robust to changes in the user-specified parameters, such as the level and number of stop placements. All findings indicate that portfolio stop-loss and stop-gain rule-based strategies comprise a promising dynamic asset allocation approach deserving of further research and development.