In the late '70s hit "The Gambler," country singer Kenny Rogers shared the secret to gambling, something I consider to be the very essence of good portfolio management: knowing what to throw away and knowing what to keep.
Stock tips are ubiquitous -- you can make a bull or bear case for anything. But even the most well capitalized investor can't bet on everything, so what matters most is how he manages those positions -- what he chooses to keep or toss away.
Rogers' advice for gamblers is similar to that old investing adage -- "cut your losers and let your winners run." Yet because it isn't flashy like insider trading or high-turnover like selling options, this fundamental truth tends to be forgotten.
Yet this old-school advice actually works. A policy of reducing your exposure to losers regardless of whether it's by 10%, 20% or some other target -- will steer portfolios to more profitable ideas and cut risk.
It also acknowledges the fact that investments don't exist in the abstract, but within individual portfolios, and that portfolio losses stem from losing trades, all of which start out manageable and small. As losses -- or the time we spend dragging them around -- grow, so does the hurdle needed to eventually turn a profit. Cisco (CSCO)has fallen
Wisdom is what keeps one generation from repeating the same mistakes of the prior. But when it comes to this most sage advice, it seems as if every new trader must learn it on his or her own. The human brain is wired for us to act in just the opposite fashion: to sell the winners (producing euphoria) and hold onto the losers (avoiding pain). It might work occasionally; you may think it works quite a lot. But over time, it's an approach that is designed to fail.
Bull and bear markets come and go with the decades, and there is always a new sector or stock in which to invest. But when it comes to the essential craft of money management, "Nihil novi sub sole", from the Latin: there is nothing new under the sun. "Cut your losers, let your winners run" has persevered over the years because it works. And it always will.
Jonathan Hoenig is managing member at Capitalistpig Hedge Fund LLC. At the time of writing, Hoenig's Fund held positions in a security mentioned in the story above.