The Value of Stop Loss Strategies
Investors tend to hold their losing investments too long and sell their winning investments
too soon (i.e., the disposition effect; see Kahneman & Tversky, 1979, Shefrin & Statman, 1985,
and Odean, 1998). Shefrin and Statman (1985) suggest that this tendency arises from behavioral
biases such as mental accounting, pride seeking, regret avoidance, and the lack of self-control.
One possible remedy for this behavioral tendency is to use stop loss strategies that prompt the
sales of losing investments. A stop loss strategy allows an investor to specify a condition under
which a losing investment is automatically sold. Since investors do not have to make
contemporaneous selling decisions, stop loss strategies can possibly prevent the behavioral
biases and help investors to realize their losses sooner. Stop loss strategies are also touted in
practice to improve investment returns.
Stop loss strategies, on the other hand, may not be efficient. If security returns are
predictable, stop loss strategies fail to incorporate relevant information from the time a strategy
is set to the time the contingent sell order is executed. When security returns are unpredictable,
selling a losing investment before the end of a holding period does not guarantee that an investor
will be better off at the end of this holding period. Although the investor will not incur any
further loss on the specific investment, he also gives up the opportunity that this investment may
recover during the rest of his holding period. Gollier (1997) and Dybvig (1988) also shows that
stop loss strategies are inefficient relative to other possible dominating strategies.
In this article we examine the impacts of stop loss strategies on the return and risk of