Prune Losers From Portfolio to Survive Crisis

Everybody has an opinion on the bailout, and those who support it do so only to the extent it might improve the performance of their stock portfolios and 401(k)s, which, if you’ve been courageous enough to look at lately, have likely dropped sharply amid the government’s efforts to “fix” the economy. As I’ve been noting for weeks, the more the feds have done the worse things have become.

Few strategies have worked. Stocks, both big and small, foreign and domestic, have been crushed. The average stock mutual fund fell 11% in the third quarter. Real estate, corporate bonds and leveraged loans have also been busts. Commodities are up for the year but have experienced a sharp reversal from their highs, just having come off their worst weekly performance in over 50 years.

We know that markets can either be bullish, bearish or trendless. And although the situation three months from now will likely look a lot different, a bull market -- a real, objective bull market -- simply isn't in the cards thanks to the impulsive, pragmatic ideology now running Washington. How can financiers invest for the future when bureaucrats are rewriting the rules on a daily basis?

So while we’re waiting for the world to change, or at least the markets, there are a few basic ideas for coping with your portfolio in the here and now. My strategy has been to preserve open, winning trades, while setting limits on how long I’ll hold on to losers that have dropped hard. So when I have a trade thesis that doesn’t work out, I’ll try and use stop-loss orders to reduce my initial commitment as the asset falls. The more it drops the more I’ll sell.

Intuitively, it makes sense. Markets aren't erratic. They move in trends that tend to persist over time. That's certainly been the case since March, when the government began directly intervening in the financial markets. So when a position becomes a loss, and the loss continues to compound, then the market is essentially telling you in no uncertain terms that, at least for now, your outlook wasn’t correct. Reducing exposure is a prudent step because it’s a shift influenced by the most objective indicator one has: the market itself. Adding to losses is akin to fighting the trend. In this market, that can be suicide.

If your portfolio is riddled with losers, I don’t believe you should indiscriminately dump them all in one day (even a day like today). The initial candidates for liquidation include tiny, “useless” positions that equal less than 1% of your portfolio, or the severe (-30% or more) losers that have long since stopped trading anywhere near your purchase price.

What hurts investors the most isn’t picking bad stocks, but sticking with and adding to them even as the price action moves the other way. It’s a reality exemplified this year by Bill Miller, Legg Mason’s (LM) highly acclaimed portfolio manager whose long-term record of beating the S&P 500 was crushed this year as he continued to add shares of financial stocks to his Legg Mason Value Trust (LMVTX) mutual fund. The market is bigger than us all, meaning that investors of every size must accept that sometimes the best approach isn't to bet your hand but fold it.