On the Inefficiency of Bang-Bang and Stop-Loss Portfolio Strategies.

We show in this article that bang-bang portfolio strategies where the investor is alternatively 100% in equity and 100% in cash are dynamically inefficient. Our proof of this 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 is optimal for investors with a nondifferentiable utility function. Copyright 1997 by Kluwer Academic Publishers