Efficiency of Stop-Loss Rules: An Empirical Study of the Swedish Stock Market

Abstract: Stop-loss rules, or predetermined policies for realizing losses based on past performance, are commonly used in the financial industry. Given the prevalence of these orders, we examine the efficiency of such stop-loss rules by measuring their marginal impact on expected return and risk, proxied by volatility, in comparison with the classic “buy-and-hold” portfolio strategy. Although stop-loss rules have been examined previously in the finance literature, this study provides a thorough analysis based on a novel data set of the complete trading records for all stocks in the OMX Stockholm 30 Index for the period January 2nd, 2006 to July 21st, 2008. Using this data set, we find strong evidence that stop-loss rules have a negative marginal impact on the expected return of a “buy-and-hold” portfolio strategy. This evidence is, furthermore, supported by our findings of short term reversals in stock returns. Moreover, although stop-loss rules seem to reduce the volatility when introduced on a “buy-and-hold” portfolio strategy, this reduction does not seem to compensate for the negative marginal impact on expected returns. As a result, we can conclude that stop-loss rules are inefficient even when we consider these policies’ marginal impact on portfolio risk.