Running for Profit

“Let your winners run and cut your losses quickly.”

This is pretty good advice when it comes to investing. Jesse Livermore coined this “trading commandment” almost 100 years ago. But it’s hard to put into practice. Studies show that investors fear losses more than they enjoy winners. So when a stock goes up they take the gain, often too early, in order to eliminate the risk of having a loss later. On the other hand, they often hang onto a losing stock in the hope of getting back to even.

As a result, many folks take small gains and let their losses run—the exact opposite of what they’re supposed to do. Over time, selling winners and holding losers gives you a portfolio of frogs and toads. So how do you avoid this?

First, you have to understand that your cost-basis is irrelevant to a stock’s performance. Many investors think a loss isn’t real unless they’ve realized it. But that is a mistake. If a stock’s price goes down, you have the loss. The price decline may be irrational, or it may improve the stock’s potential return, but the loss has happened. Hoping the price will come back up won’t make it so.

On the other hand, trimming a winning position is good risk-management. If a winner grows until its performance dominates a portfolio, that’s an excessive bet on one company. It doesn’t matter how the exposure grew—it’s become too high, and should be cut back.

Letting winners run while trimming them is part of sound portfolio management. It’s too bad that more people don’t take this advice.

Douglas R. Tengdin, CFA
Chief Investment Officer
Hit reply if you have any questions—I read them all!

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