Advanced Portfolio Management

Chapter 9Manage Your Losses

• What will you learn here: Whether you need a stop-loss policy; what are the trade-offs and how do they depend on your performance parameters?
• Why do you need it: Because, in the long run, your survival as a fund or portfolio manager will depend on setting an effective stop-loss policy. Hence, it is extremely important.
• When will you need this: You will set the policy very rarely – usually, only once in the lifetime of a fund. For a portfolio manager, the policy will be binding much less than once a year.

To many readers of this book, loss management is the only form of risk management that matters. “Factors”, “alpha”, “optimization”, “risk limits”: these are all modeling constructs; PnL, on the other side, is tangible. A large loss is a threat to the survival of a fund. A simple evasive strategy is to fly from the threat. In an investment strategy, this means liquidating stock holdings into cash. This is often referred to as a “stop-loss” policy. When some threshold is reached, a partial or total liquidation occurs. The rule does not require data or complex models; it is simple; it resonates with human behavior; and it seems necessary. Yet, there is no agreement on stop-loss policies. The first section of this chapter is devoted to exploring the arguments in favor and against these policies. The second section connects the design parameters of the policy to the investor's own characteristics and goals. Finally, we look at variants of the ...