On the Inefficiency of Bang-Bang and Stop-Loss Portfolio Strategies
J. OF RISK AND UNCERTAINTY, Vol. 14 No. 2
Posted: 13 Feb 1997
Abstract
We show in this paper that bang-bang portfolio strategies where the investor is alternatively 100% in equity and 100% in cash are dynamically inefficient. Our proof of this result is based on a simple second-order stochastic dominance (SSD) argument. It implies that this is true for any decision criterion that satisfies SSD, not necessarily expected utility. We also examine the stop-loss strategy in which the investor is 100% in equity as long as the value of the portfolio exceeds a lower limit where the investor switches to 100% in cash. Again, we show that this strategy is inefficient under second-order risk aversion. However, a slight modification of it - in which all wealth exceeding a minimum reserve is invested in equity - is shown to be an efficient dynamic portfolio strategy. This strategy is optimal for investors with a non-differentiable utility function.
JEL Classification: D80, G10, G11
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