"CUT YOUR LOSERS

and let your winners run."

It's a trading rule as old as the market itself. But while amateurs and pros alike are familiar with the saying, few have thought about the logic behind it. A few weeks ago we talked about the importance of letting your winners run. This time, we'll focus on the first and more difficult half of the formula: taking losses.

The human mind is a powerfully manipulative beast, and the biggest problem most people have is that their inner beast interprets losing trades in exactly the wrong fashion. Simply put, we ignore the reality of losses while simultaneously counting our winning chickens before they're hatched. Within our portfolios, we too often treat a paper loss as a temporary phenomenon, while a paper gain is wrongly seen as money in the bank. This is a logical fallacy to which almost all of us fall pray. But the truth is, a gain is only a gain once you've taken it, while a loss is a loss whether it's realized or on paper.

The stock market, like many areas of our lives, moves in trends. Weak stocks tend to get weaker or, at least, stay weak. If you're in the enviable position of being able to take a risk, with more than 10,000 publicly traded securities out there, why opt for an already losing trade? As we pointed out over the past few months, there's always a bull market somewhere even if it's not in Microsoft, Merck or the washed up names of the Standard & Poor's 500. When a stock is declining, it's telling you something don't buy me.

Like music, fashion or any other cultural trend, you always want your portfolio to be positioned forward, and although the most informed decisions are by definition the most recent ones, most investors find it difficult to let go of losing trades from years gone by, no matter how many better alternatives might be available in the current market environment.

From precious metals to fixed income, there are winning ideas in today's market. And while I think large-cap stocks could move higher given their dramatic decline, there's not a technical or fundamental foundation in the world to suggest they represent the best investment ideas right now. I have to laugh as the pundits continue to tout the value in Pfizer, General Electric and other S&P stalwarts. To me, big-cap stocks are the investment equivalent of eight-track tape players and fondue pots: They're kitschy and nostalgic items that belong in the attic or the dumpster not in your portfolio of best new ideas. These days, I'd play the weak-dollar, hot real estate or smoking commodities markets before plowing more than a few bucks back into the S&P, where losing trades rule the day.

When you're in a losing trade, the real cost isn't just the dollar amount, but the time value of money compared with better, more immediately promising investments. What matters ultimately are compound interest and absolute return. Every second that ticks by is an opportunity to be making money even if only by compounding in cash at the risk-free rate.

That's the real danger of losing trades: Because they tend to stay losing trades often for longer than anyone might imagine every second you hold onto a loser demands that it must eventually become an even bigger score in the long run to justify holding it at all.

A trader should be a realist, not an optimist. While I think AOL Time Warner will eventually get back up to $55 a share, I wonder how long that comeback might take. (We offered some frightening suggestions last year and again a few months back Even in an environment of historically low inflation, can you afford to find out how long the "long haul" really is?

Another problem with holding onto losing trades is that they tend to make effective position sizing next to impossible. As we've written in the past, any individual trade should encompass only a small portion of an overall portfolio. When a stock declines precipitously, it throws off your portfolio's composition dramatically. To paraphrase General MacArthur, old stocks don't die they just fade away. By the time a stock has declined 15% to 20% from your purchase price, its net portfolio effect is usually too small to justify holding it anyway. This is especially true if your overall portfolio has increased in value despite the individual stock's decline.

By and large, I believe that any losing position that encompasses less than 1% of your portfolio should be sold. Although it's difficult to throw in the towel, in my experience, the extra half-percentage-point of liquidity is more valuable than the investment prospects for a small position in a weak stock. And when it comes to larger losing positions, I advocate a "worst first" attitude. The biggest should be the first to go. Think like Gordon Gekko: Positions either perform, or they get eliminated. End of story.

Every trader has losers, and by using tax swaps, options or stop orders, it's possible to take them skillfully. Whether you're boring or creative, one way or another, you've got to sell those dogs to stop them from biting you some more.

Jonathan Hoenig is portfolio manager at Capitalistpig Asset Management. At the time of writing, Hoenig's fund had positions in many of the securities mentioned here.