You Don't Want To Hear It, But You Shouldn't Use Stop-Losses
You may want to skip this article for a pre-established understanding of the use of stop losses, but you should read it.
One of the authors who has most influenced my way of understanding the markets has been Benoit Mandelbrot, not only has he been a great influencer for me, but for other very prominent people in this world such as Nassim N. Taleb.
One of the main contributions that Mandelbrot made was to find a new branch of mathematics, already applied to many physical principles, to financial markets. This new branch perceives the hidden order in the seemingly disordered, the plan in the unplanned, the regular pattern in the irregularity and roughness of nature, which is called fractal geometry.
This way of understanding markets was based on the principle that markets jump and are totally impossible to predict. On the other hand, the distribution of returns did not follow a log-normal distribution as had been established up to that moment with the Black-Scholes formula. Furthermore, he added that there is no way to distinguish between a daily, weekly, monthly or decade chart.
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To prove this claim Mandelbrot gives the example of the following 4 stock charts and invites the reader to guess which of them are false and which are true:
As you can see with the naked eye they could all be true or false and there is no possible way to distinguish them. The only possible way to distinguish them is through the price change, which is exactly what the following graph shows us:
Now, do you know which are true and which are false? If you still don’t know, I’ll tell you, the real ones are 1 and 3, while 2 and 4 are invented. As you can see, the jumps made by both the first and the third daily are some of them of a much greater magnitude than would be expected from the distribution of results.
The theory tells us that from 1916 to 2003, there should only have been 58 days in which the index had moved more than 3.4%, however, there have been 1,001 movements of this magnitude or greater. Continuing with this example, the theory tells us that in this period there should only have been 6 days with movements greater than 4.5%, however, there have been 366.
With all this, I wanted to reach the conclusion that ‘stop-loss’ orders are imperfect and that, although we establish limited orders at a certain price, the markets jump due to their nature. This can cause orders not to be executed at the set price but at a much lower price, as the broker may not execute the orders fast enough. The result is that the losses for the investor are maximized.
Our purpose is to convey to the individual investor simple strategies to have a covered, uncorrelated and asymmetric portfolio as possible so that any investor can implement this strategy for himself. One of the main strengths of this strategy is to be able to sleep peacefully each and every night and for this, we have between 40–60% of the portfolio invested in fixed income (other currencies, bonds, gold …) and the rest is invested in options or ETFs that make us benefit from any market situation
This article is for informational purposes only, it should not be considered Financial or Legal Advice. Not all information will be accurate. Consult a financial professional before making any major financial decisions.