Holding winners for longer and selling losers faster is a well-established rule of thumb for investors and traders alike.
The idea is to offset the natural response of most people, which is to quickly sell winners (in order to lock in profits) while hanging onto losers for all eternity (in order to avoid locking in losses).
However, I’m not a fan of riding winners and cutting losers, at least as it’s commonly practised. Here’s why:
Letting “winners” run is a risky strategy
At first glance, letting winners run seems like a sensible idea. We know there’s a momentum effect, so when the price of one of your investments shoots up you should sit back and just let it rip. That’s the theory at least.
But how long should you let winners run? A month? A year? Forever?
Here’s a personal example:
In early 2011 I bought some JD Sports shares for 45.6p (adjusted for splits). That was a good idea because JD Sports eventually turned out to be a real winner in terms of share price gains.
I say eventually because it didn’t really get going until the middle of 2013. So I had to wait two years before seeing any capital gains, but after that the share price took off like SpaceX‘s Falcon Heavy rocket.
And I’m not joking either. At their peak in early 2017, JD Sports’ shares were worth 450p each, approximately ten-times what I’d paid for them in 2011.
That’s an awesome gain, so what might a “letting winners run” approach look like in this case?
Here’s a plausible scenario:
- You invested in JD Sports in early 2011 at 45p per share
- You put 1/30th of your £100,000 portfolio (3.3% or £3,300) into this investment because you like to hold 30 stocks (as I do)
- This was the only good investment you made and the rest of your portfolio went nowhere between 2011 and now
When JD Sports hit its peak price of 450p in early 2017 your £3,300 investment would have ballooned to £33,000, which is obviously a good result.
On top of that, you whole portfolio would be worth £128,300, which is a 28.3% gain despite your other investments going nowhere.
But there’s a catch: Your JD Sports investment now makes up almost 26% of your portfolio and that is a massive risk to take.
After all, companies can go from good to bad to bust in just a few short years with the wrong management in charge (I won’t mention Carillion as the obvious example).
So if your starting position size of 3.3% was a reasonable amount to risk on a single company, is it sensible to have 26% invested in one company when this could happen?:
- JD Sports’ existing CEO retires and a new CEO takes over
- The new CEO goes on a debt-fuelled acquisition spree, buying up sports clothing companies all over the world and leveraging the company to the hilt
- Those acquisitions are troublesome and take time, effort and focus away from the company’s existing and highly successful core brands
- Those core brands struggle from a lack of attention and investment and lose their competitive position
- Interest rates spike upwards, increasing the company’s debt interest payments
- The combination of a weakening core business and suffocating interest payments leads to either a) a massive rights issue, diluting existing investors to the point where all previous gains are wiped out or b) the company defaults on its debts and joins the long list of good businesses that were killed off by bad management
That scenario is entirely possible, which is why investors need to control risk by controlling their exposure to any one company, sector or country.
Hopefully my position so far is clear: Letting winners run and run is a bad idea because it completely ignores the winner’s position size and therefore its risk to the overall portfolio.
To avoid this problem, I use the following “rebalancing” rule:
- REBALANCING RULE: If a holding grows to twice the default position size, sell half the position in order to maintain diversity
This will definitely reduce risk, but…
Rebalancing winners has its downsides too
Looking at my personal experience with JD Sports again, following the above rule led to a rebalancing when JD Sports reached approximately 6.6% of my portfolio (I say approximately because this isn’t an exact science).
That occurred in October 2014 when the shares hit 90p in late 2014.
At that point I rebalanced JD Sports from 6.1% of my portfolio down to 4% and reinvested the proceeds into new investments over the next few months (I didn’t rebalance all the way back to 3.3% because I wanted to minimise how much cash I had to reinvest elsewhere).
JD Sports then went up by another 50% over the next 18 months, so I had to rebalance again. Then it went up by another 50% in just six months and so yes, I rebalanced yet again.
All of this rebalancing meant that my JD Sports investment produced capital gains of 221% between the first purchase in 2011 and when I finally sold the company in 2015 (I sold the company because the valuation was no longer attractive, which I’ll cover shortly).
If I’d simply held on for the long-term and let this winner run (and ignored the stretched valuations in 2015 and beyond) then the capital gains would have been around 1,000% at the peak in 2017.
So yes, with hindsight, letting JD Sports run would have been far more profitable, but without hindsight that would have been a very risky thing to do and I would have eventually ended up with 25% or more invested in one company.
For me, controlling risk trumps everything else, so the idea of letting winners run needs to be stated within the context of risk.
And risk doesn’t just mean the position size, although that is perhaps the most important risk. It also includes other important risk factors such as valuation risk and business risk.
So a modified “let winners run” rule might look like this…
Let winners run, but only if these risk factors are within acceptable levels:
- PRICE RISK: Control position size by rebalancing when a position reaches 6.6% of the portfolio (or whatever your preferred maximum is)
- VALUATION RISK: Sell the entire position when the stock’s valuation ratios are no longer attractive
- BUSINESS RISK: Sell the entire position when the company is no longer attractive (e.g. when it is no longer growing, paying dividends or producing attractive returns on capital without excessive leverage)
However, some investors might argue that it would still have been better to hold onto JD Sports, do no rebalancing and capture the whole 1,000% capital gain.
Those investors might argue that a better approach to controlling risk is to sell a stock, even a winning stock, as soon as it becomes a loser.
Here’s what I think:
Selling “losers” makes no sense at all
For most people, “selling losers quickly” means using a trailing stop loss.
If an investment falls by, say, 20% from its peak, the shares are sold automatically.
This is an entirely reasonable strategy for momentum traders, but for long-term business investors it makes no sense at all.
My main problem with stop losses is that they give decision-making powers to the market.
For example, one day you’re holding shares in Company A and you think it’s a good company at a good price. But the next day its share price falls by 20% and you’re stop loss kicks in and sells the entire position.
So the market has effectively told you that this is no longer a good company at a good price at that the investment should be sold.
The decision to sell was based purely on the fact that the share price declined by 20% from a previous peak. It doesn’t take into account any news about the company’s current situation or its long-term future. No: The price fell so the shares are sold.
I’m sure you’ve seen this quote before, but I’ll wheel it out anyway as it’s absolutely central to how I believe long-term investors should think:
“Mr. Market is there to serve you, not to guide you. It is his pocketbook, not his wisdom that you will find useful. If he shows up some day in a particularly foolish mood, you are free to either ignore him or to take advantage of him, but it will be disastrous if you fall under his influence. Indeed, if you aren’t certain that you understand and can value your business far better than Mr. Market, you don’t belong in the game.” – Warren Buffett, 1987 letter to Berkshire Hathaway shareholders
For long-term investors, a 20% decline in a company’s share price tells you nothing about a company or its prospects.
It simply tells you that today some investors who you have never met were willing to buy and sell shares in the company for 20% less than some other investors (who you have also never met) were to pay or accept before.
But so what? As an active long-term investor it is your job to analyse and value companies. The market’s job is to allow you to buy and sell shares in those companies as and when it suits you.
In other words, the market provides liquidity, not advice.
If you think the market knows more about the companies you’re investing in than you do then you shouldn’t be picking stocks. Instead, you should invest using the Efficient Market Hypothesis, Modern Portfolio Theory and other “efficient market” ideas.
Let’s turn back to JD Sports for an example of just how little the market knows about the future.
I bought shares in JD Sports for just over 45p in early 2011.
By November 2011 the shares had declined by 20% to 36p, so any investors using a 20% stop loss would have been stopped out with a quick 20% loss.
I assume those investors would have been happy to have “escaped” from what was then thought of as a struggling ho-hum retailer, especially as the shares eventually fell almost 40% below my purchase price, to less than 29p by the end of 2012.
A lucky escape? No, because the market has no idea what the future holds, which is why it’s such a bad idea for investors to pay attention to it.
In this case, JD Sports’ shares climbed from that terrifying low of 29p in December 2011 to a gloriously excessive 450p in May 2017, a gain of about 1500% in less than six years (about 65% per year).
Is that what you’d expect from an all-seeing all-knowing “efficient” market? I don’t think so.
For me the market is neither efficient nor intelligent. It is simply a mechanism to allow investors (whom I don’t know) to buy and sell shares (for reasons that I don’t know) at a price which they deem to be acceptable (using criteria which I don’t know).
The fact that a company’s share price goes from 29p to 450p, or from 450p to 29p, tells me absolutely nothing about the company or its prospects. And for that reason, comparing share prices from one point in time to another point in time is something I absolutely never do.
The only thing a long-term investor should compare share prices to is the long-term fundamentals of the underlying company.
Now that I’ve got that off my chest, what are my rules for selling, if not to simply “sell losers quickly?”
My rules for selling are the same as my rules for holding
My rules for buying, holding and selling are all based on the idea that my portfolio should be filled with a diverse group of good companies trading at attractive valuations:
- A diverse group means around 30 companies operating in a wide range of sectors and countries, with no one company taking up more than 6% or so of the portfolio
- Good companies means companies that have features like low debts and high profitability, and the potential to grow their dividends over the long-term
- Attractive valuations means that expected returns to shareholders should be above average, thanks to decent dividend yields to go along with the hoped for dividend growth
Once I’ve bought a company I’ll hang onto it for as long as the above factors remain true, i.e. that the various risk factors (price risk, valuation risk and business risk) are acceptable.
Typically I’ll only sell six companies each year at a rate of one every other month (e.g. January, March, etc.). This gives me plenty of time to think about what I want to sell and, more importantly, it stops me from making knee-jerk decisions, especially ones based on sudden share price declines.
So as per my comments on letting winners run, I’ll hang onto an investment as long as its:
- Position size is acceptable (I’ll cut a position in half when it reaches 6% or more)
- Valuation ratios are acceptable (I’ll put the company on my “sell waiting list” if the valuation ratios become too stretched)
- Fundamental factors are acceptable (I’ll put the company on my “sell waiting list” if any of its fundamental factors – such as balance sheet strength, profitability or growth rate – fall outside my minimum standards)
Letting winners run and cutting losers is a trading strategy, not an investment strategy
In summary then, if you’re a momentum trader then letting winners run and cutting losers quick is a legitimate trading strategy.
But if you’re a long-term investor who wants to invest in businesses through the stock market, then holding an investment just because it’s price has gone up, or selling an investment just because its price has gone down, makes no sense at all.
I’ll leave you with one final quote:
“Some investors — really speculators — mistakenly look to Mr. Market for investment guidance. They observe him setting a lower price for a security and, unmindful of his irrationality, rush to sell their holdings, ignoring their own assessment of underlying value. Other times they see him raising prices and, trusting his lead, buy in at the higher figure as if he knew more than they. The reality is that Mr. Market knows nothing, being the product of the collective action of thousands of buyers and sellers who themselves are not always motivated by investment fundamentals. Emotional investors and speculators inevitably lose money; investors who take advantage of Mr. Market’s periodic irrationality, by contrast, have a good chance of enjoying long-term success.” – Seth Klarman, Margin of Safety
If you search the Web for “Mr Market” you’ll find a ton of articles and quotes on this topic. This Mr Market article from Value Walk has some of the best quotes on a single page.