Stop-loss strategies with serial correlation, regime switching, and transaction costs

• Published in: Journal of financial markets (Amsterdam, Netherlands) Vol. 34; pp. 1 - 15
• Main Authors: Lo, Andrew W., Remorov, Alexander
• Format: Journal Article
• Language: English
• Published: Elsevier B.V 01.06.2017
• Subjects: Asset allocation; Behavioral finance; Investments; Portfolio management; Risk management; Stop-loss strategy; Stop-loss strategy; Asset allocation; Investments; G11; G12; Risk management; Portfolio management; Behavioral finance
• ISSN: 1386-4181; 1878-576X
• DOI: 10.1016/j.finmar.2017.02.003

Stop-loss strategies are commonly used by investors to reduce their holdings in risky assets if prices or total wealth breach certain pre-specified thresholds. We derive closed-form expressions for the impact of stop-loss strategies on asset returns that are serially correlated, regime switching, and subject to transaction costs. When applied to a large sample of individual U.S. stocks, we show that tight stop-loss strategies tend to underperform the buy-and-hold policy in a mean-variance framework due to excessive trading costs. Outperformance is possible for stocks with sufficiently high serial correlation in returns. Certain strategies succeed at reducing downside risk, but not substantially. •Stop-loss strategies are commonly used by investors to manage risk when facing portfolio losses beyond a certain threshold .•We derive closed-form expressions for the impact of stop-loss strategies with serial correlation, regime switching, and transactions costs.•For a large sample of U.S. stocks, tight stop-loss strategies underperform buy-and-hold due to excessive trading costs.•Stop-loss outperformance is possible for assets with sufficiently high return autocorrelation returns.•These results are important for both theory and practice, given the ubiquity of stop-loss orders and their academic critics.