‘Cut your losses short and let your winners run.’ There’s good chance you’ve heard this rule before — it’s well known amongst traders.
It’s a good rule to keep in mind. Investors often hold on to losers for too long, hoping to see a recovery. And it’s not unusual for investors to sell winners too soon and miss out on further gains.
The first part, ‘cut your losses short’ is straightforward: Use stop losses. Stop losses keep your losses under control. They introduce discipline and tell you when to sell.
You can use various types of stop losses. A common one is to set the stop a certain percentage below the buy price. Another option is to set it with the help of technical indicators, placing it at support or resistance levels, for example. Using stop losses to reduce your investment risk was discussed not long ago in The Markets and Money by Albert Park Investors Guild Chairman, Bernd Struben. Click here if you missed it.
Stop losses will give you a definitive price at which you should sell. But it’s not as easy to tell if you’ve left it too late to buy, or whether you’re selling a winner too soon.
‘Let your winners run,’ can be a difficult rule to observe. Emotionally, it can be hard to adhere to.
That’s especially true if you have doubts around whether the stock has much left in the tank. It can be tempting to take your gains and not look back.
How do you approach a stock in your portfolio with large gains? How do you decide if it’s it time to cash out and move on? Or if it’s still a great opportunity with further to run?
Many investors worry that if a stock’s had a good run, it’s due for a pullback. Yet it’s not unusual for quality stocks to keep on performing.
In fact, this is exactly the scenario facing members of the Albert Park Investors Guild. I recommended a stock in August last year. At that time, it had already returned investors 4,000% since its 2009 lows. I warned members, ‘When share prices have seen this kind of growth, you need to be careful that the rally isn’t about to come to an end.’
However, my research indicated that the stock would continue to be a great investment. That proved to be correct, as it has gained another 70% since I recommended it. The question now is — can it keep climbing higher? Or is it time to sell?
And for members who didn’t follow my advice in August, those on the sidelines, watching it rise week after week, the question is whether they’ve left it too late to buy.
Just last week, Bill Bonner discussed this phenomenon in The Markets and Money:
‘You buy a stock. It doubles. What do you do?
‘Many investors would sell, feeling that they had made a good profit. Why be greedy?
‘Often, they then watch as the stock goes higher and higher, as they sit on the sidelines grousing about having gotten out too soon.’
Bill’s answer was to use trailing stops. Trailing stops go a step further than regular set stop losses. They are set a certain amount — either a percentage or dollar amount — below the highest price a stock has reached since you bought it. This means that as a share’s price rises the stop level rises with it.
Trailing stops are great for limiting your losses, and I recommend you apply them to your own portfolio. You don’t have to set the stop levels with your broker. You can simply keep track of them in a spreadsheet and then sell the day after the stock closes below the stop level.
But I’m not convinced that they are the best way to decide when to sell a winner and take gains. It does create discipline, but you’ll always be giving back some gains by waiting for the price to fall to the trailing stop level. If you only sell when you hit a stop loss, you’ll never sell at the best possible price.
I prefer to regularly evaluate each stock to make sure it still has all the characteristics of the stocks I want in my portfolio. I use trailing stop losses as an extra safety net.
The Guild has strict criteria that all stocks must meet before being added to the portfolios. And just as importantly, they must continue to meet these requirements as time goes by. These are set out in a special report available to members. If you’d like to know more, this is a great place to start.
What you’re really considering is the opportunity cost. That is, by buying a stock or staying invested in it, you are foregoing the opportunity to be invested in another stock — which may or may not be a better investment.
It’s important not to take a ‘set and forget’ attitude. Regularly analyse the stocks in your portfolio so that you’re confident that they are the best assets for you to be invested in. Of course, this will be different for everyone…you’re not all looking for the same attributes.
As for the stock I mentioned above in the Guild, it remains a Buy since it still meets all the criteria required to be held in the portfolio — that is, it’s a sound, well-managed company with low debt, plenty of cash, and a promising future. The 70% gains it delivered to members so far should be just the beginning.
Schedule time to regularly evaluate the stocks in your portfolio. Take the view that you don’t already own them. And then analyse them in the same way you would any new stock purchases. If they don’t meet your criteria, sell. Then move on to something more promising.
Investment Director, Albert Part Investors Guild