Selling Losers as They Rally Is Big Mistake

As regular readers know, it's my belief that portfolio management has a much bigger impact on the bottom line than simple stock picking. One of the worst and most commonly practiced offenses is the sin of waiting for XYZ, held at a loss, to get "back to even" before finally getting out.

You know the deal: You buy XYZ at $50 a share and, for whatever reason, it proceeds to drop. Believing that a paper loss isn't a real loss, you hold on even as the stock continues to slide and the fundamentals falter. The lower it falls, the more you dig in your heels, ready to take the stock to the grave rather than admit defeat. Who says trading isn't emotional?

I've often written about the importance of taking investment cues from objective reality; that is, the price action of the securities themselves. But holding on to large losing positions is, almost by definition, the essence of fighting the tape. If I'm down 20% in shares of XYZ, then it's my judgment that's off, not the market's. The market is never wrong. Investors, even the talented ones, are wrong all the time.

The problem is compounded when people resolve to "sell when I get to even." In other words they wait to exit a laggard trade once it has recouped the majority of the losses or shows a slight gain. Even if we've held XYZ for two years while shares dropped 40%, we sell once the loss has become a slight gain, relieved to finally exit the trade and make a small profit.

In the midst of a fast market when the money is flying, it's often easy to be led by your gut instead of your head. But by removing ourselves from the moment, we can see why, on average, waiting to sell "when you get back to even" is exactly the wrong approach.

The reality is losing trades are unproductive uses of capital, and that the time value of money is significantly more important than the ego hit of having to take a loss. The sooner you can cut your mistakes, the quicker precious resources can be focused on more promising ideas. The best traders aren't those who never have losses, but those who are comfortable with admitting their mistakes and quickly moving on to better opportunities.

But the real rub comes when the stock finally does rally back to the level at which you originally thought XYZ was such a steal. Having sat on dead money for so long, you quickly look to sell shares as soon as you're "even."

Yet you liked XYZ at $50. If it has dropped to $25 and has been able to over time march all the way back to $50, that's exactly the wrong time to consider selling it. After all, the stock is now poised to make the move you originally foresaw. But because you're emotionally weakened after having nursed a loss for so long, you want nothing more to do than to protect your ego and get out.

Wal-Mart Stores (WMT) presents a contemporary example. After years of stagnant stock performance, the retailing giant's stock has enjoyed a strong first quarter, rising to a three-year high even as the rest of the market wilted. Many investors, underwater for several years, are no doubt taking advantage of the higher prices to finally exit positions originally taken earlier this decade.

Yet what matters isn't how a stock acted six years ago, but how it's acting in the here and now. If you've dragged Wal-Mart around all this time and are finally starting to see a return, then I'd suggest now might be the moment to add to the position rather than rush to trade it away.

Because trading is emotional, we have a tendency to personalize every tick. Yet the stock doesn't "know" you bought it at $50. Every day thousands of other people are making value judgments that are independent of your own choice to buy XYZ.

So the fact you bought XYZ at higher prices shouldn't negate the importance of getting out once the name has moved against you. And if you do insist on dragging around losing trades like old laundry, don't make the mistake of selling them once the stock has finally regained your original price. More often than you'd think, that's not the end of the trade but the beginning of the bull move you anticipated all along.

Jonathan Hoenig is managing member at Capitalistpig Hedge Fund LLC.