The Value of Stop-Losses and Stop-Gains in Enhancing Risk-Adjusted Return

Abstract

Asset allocation strategies which utilize stop-loss and stop-gain rules may dramatically decrease risk and even increase long-term return relative to passive investing. I introduce an asset allocation strategy which shifts portfolio weights based on simplistic stop rules. The two-asset (S&P mutual fund and bond mutual fund) strategy tested from 1990-2012 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% annualized standard deviation of return vs. 18.76% for the S&P index fund). The strategy’s strong results are robust to changes in the user-specified parameters, such as the level and number of stop placements. Hence, further development and refinement of asset allocation and trading strategies which incorporate stop-loss and stop-gain rules may be a valuable area of future research.