When Do Stop-loss Rules Stop Losses?

Stop-loss rules-predetermined policies that reduce a portfolio's exposure after reaching a certain threshold of cumulative losses-are commonly used by retail and institutional investors to manage the risks of their investments, but have also been viewed with some skepticism by critics who question their efficacy. In this paper, the authors develop a simple framework for measuring the impact of stop-loss rules on the expected return and volatility of an arbitrary portfolio strategy, and derive conditions under which stop-loss rules add or subtract value to that portfolio strategy. They show that under the Random Walk Hypothesis, simple 0/1 stop-loss rules always decrease a strategy's expected return, but in the presence of momentum, stop-loss rules can add value.