The consistency of a trend following strategy’s relative performance vs a 60/40 portfolio (impacting the ability for investors to stick with trend following) is the basis of an argument that’s taken place offline (yes, I also argue offline) with a FinTwit friend who is a huge proponent of buy and hold. It’s progressed to the point that we’ve discussed making a mini (very mini) Buffett style bet related to whether trend following or a 60% US Stock / 40% Bond allocation will outperform over the next five years (with money going to the winner’s charity of choice).
From a 2015 post at Quant Investing, a look at 3 research papers on the use of stop losses.
Study 1: When do stop loss rules stop losses?
What they also found was that the stop-out periods were relatively evenly spread over the 54 year period they tested. This shows you that the stop-loss was not just triggered by a small number of large market movements (crashes).
Study 2: Stop Losses, Trailing, and Buy & Hold compared
Trailing better than traditional
Only at the 5% and 10% loss levels did the traditional stop-loss perform better than the trailing stop-loss. At all other loss levels the trailing stop loss out performed, most notably at the 20% loss level where it performed 27.47% better over the 11 year period.
Study 3: Stop Losses in Momentum Investing
The stop-loss momentum strategy also completely avoided the crash risks of the original momentum strategy as the following table convincingly shows.
Click image to enlarge
Note that if you followed a stop loss strategy you would have made a small profit when the momentum only strategy lost nearly 50% and 40%.
The studies actually convinced the author to change is opinion on stop losses:
This has been a rather long article to come to a very clear and simple conclusion: Stop-loss strategies work
As you have seen:
- When applied to a 54 year period a simple stop-loss strategy provided higher returns while at the same time lowering losses substantially
- A trailing stop loss is better than a traditional (loss from purchase price) stop-loss strategy
- The best trailing stop-loss percentage to use is either 15% or 20%
- If you use a pure momentum strategy a stop loss strategy can help you to completely avoid market crashes, and even earn you a small profit while the market loses 50%
- Stop-loss strategies lowers wild down movements in the value of your portfolio, substantially increasing your risk adjusted returns
via Truths about stop-losses that nobody wants to believe at Quant Investing for Value, Momentum, Quality and Growth stocks
momentum works for a fundamental reason – it’s the natural evolution of creative destruction. You could say that all market cap weighted index funds are momentum funds because they more or less reflect the process by which corporations succeed and fail.
via Why Does Momentum Investing Work? – Pragmatic Capitalism at Pragmatic Capitalism