“Let your winners run, and cut your losses quickly.” – Jesse Livermore
Ancient Greek Runners from a pottery shard. Public Domain. Source: Wikipedia
This is pretty good advice when it comes to investing. The legendary investor Jesse Livermore coined this “trading commandment” a century ago. But it’s hard to put into practice. Studies show investors fear losses more than they enjoy winners. When a stock goes up we take the gain, often too early, in order to eliminate the risk of losing it later. On the other hand, we hang onto a falling 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 us a portfolio of frogs and toads. So how do we avoid this?
Photo: WikiImages. Source: Pixabay
First, we have to understand that our cost-basis is irrelevant to the stock’s performance. The stock doesn’t know that we own it. Many investors think a loss isn’t real unless they’ve realized it. But that’s another mistake. If a stock’s price goes down, we 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 do anything. Hope is not a plan.
On the other hand, trimming a winning position is good risk-management. If a winner grows until its performance dominates the portfolio, that’s an excessive bet on one company. It doesn’t matter how the exposure grew—it’s too high, and should be cut back.
Letting winners run while trimming them is part of sound portfolio management. It’s unfortunate that more investors don’t – or can’t – take this advice.
Douglas R. Tengdin, CFA