From Cabot Wealth Advisory 8/20/09 Sign up for free Cabot Wealth Advisory e-newsletter
Any growth-stock investor worth his salt cuts all his losses short. Whether it's at 5% or 15%, at some point, any good investor who's going to have success over many years will cut losses. Also, any investor who's going to make good money in the market takes good-sized positions. Thus, for purposes of this discussion, I'll assume all losses are cut short, and that position sizes are big enough to matter (each position in the range 7% to 15% of your total portfolio).
So then the question becomes ... how do you handle your winning stocks? I've been thinking a lot about this subject in recent days and weeks, an I've concluded it comes down to a battle between drawdowns and profit potential. Let me explain.
On one hand, drawdowns (i.e., selling a certain percent off a stock's peak) can really work against you. If you buy a stock and it rises 25%, but then it falls 15% off its top and you sell it, your total profit is just 6%. If you don't sell it until it's down 20%, your profit has been erased; you're back to breakeven. And that doesn't take into account that, by the time a stock has dropped 20% from its high, it's often wiped out a couple months' worth of gains.
On the flip side, however, is profit potential. If you take the above paragraph to heart, you'll sell everything as soon as you have any profit at all. But if you do that, you'll never develop a large winner...and large winners are where most of an investor's gains come from over the long run.
Thus, there's a natural "tension" between booking profits and letting them run. So if you want to make big money, you'll need to choose a strategy that can maximize gains while minimizing headaches.
Offensive versus Defensive Strategies
That leads me to several general strategies you can use to manage your winning stocks. This won't be as much about specific selling rules as it will be about guidelines for your average winning stock. (I'm happy to write about some technical indicators that can help you sell stocks better in future Advisories.) So here is a range of possibilities to consider.
Strategy 1: Sell every winner when it rises a certain percent (10% or 15%) from your buy price.
Advantages: Drawdowns minimized, so portfolio results will be smoother. You will be buying and selling relatively quickly so you can focus on the best set-ups and opportunities and you won't get attached to stocks.
Disadvantages: No chance of landing a big gain. Profits in portfolio are totally dependent on "win percentage"—i.e., if half your stocks are losers, which isn't uncommon, you won't make much money. Very hard to have a truly great year.
What kind of investor it's best for (with a cheesy baseball analogy thrown in): The disciplined stock picker who abhors drawdowns and wants to make relatively consistent profits (though not great profits) over time. A singles hitter.
My take: Unless you're a nimble short-term trader with great discipline, it's going to be tough to make money if you're cutting every profit short.
Strategy 2: Sell winning stocks using trailing stops (15% to 20% off a stock's recent peak), or when it falls through support, such as the 50-day moving average.
Advantages: Opportunity to land big gains. Usually allows you to ride a winner for as long as the stock wants to run.
Disadvantages: Drawdowns will be horrible. When one stock begins to pull back, chances are your other holdings will do the same. Thus, a solid portfolio gain (say you're up 20% for the year) can disappear in a hurry since all sell stops will be so far below the stocks' highs.
What kind of investor it's best for (with another cheesy baseball analogy): The investor who's aiming for longer-term returns and doesn't mind seeing 5% or 10% of his portfolio go by the wayside during sharp market corrections. A power hitter looking for doubles, but who also strikes out a bunch.
My take: In the very long run, this method will produce large gains...but also choppy gains. It might not produce any profits for a couple of years, but then can dazzle when it latches onto a few big winners.
Strategy 3: After buying a stock, average up in price the first couple of times it rises 5% or 10% above your last buy (if you bought at 50, you might buy some more at 55 and then again at 60). To sell, you use a trailing stop or the 50-day moving average.
Advantages: Any single big winner (100% increase or more) could drive your portfolio's results for the whole year. Your biggest position sizes will naturally be in the best performers because of averaging up.
Disadvantages: The vast majority of your stocks will either be losers or breakeven trades. Only the rare 50% to 100%-plus winner will push your portfolio higher. Because it could take a year or more to find that winner, your portfolio's returns could be sour for long stretches before striking gold.
What kind of investor it's best for (with yet another baseball analogy): The kind who is solely gunning for huge gains over time, and doesn't care about near-term performance. Also the kind who recognizes that big winners take TIME to play out even if it's been a year since finding one, the investor must have the patience to ride through a few painful corrections. A homerun-or-strikeout type of hitter.
My take: This method probably produces the very best gains over time. But the drawdowns and lack of consistent upside means you need to truly love finding and riding the major winners, and have great confidence in yourself. It's very tough to pull off.
Strategy 4: Sell a portion of your winner (one-quarter to one-half) when it's up a reasonable amount (10% to 15%), then ride the rest of the shares using a trailing stop.
Advantages: Able to sock away a small amount of profit quickly, yet you can still benefit from a big winner.
Disadvantages: Your position sizes get reduced quickly, lessening the impact of a big winner. And the profit taken by selling a small portion of a small winner can be, well, small.
What kind of investor it's best for (with a final baseball analogy thrown in): One who can't stand the volatility of having big positions in a few volatile growth stocks, yet still wants to hit a homerun every now and then. The all-around hitter who sprays mostly singles, a few doubles, and a homer every now and then.
My take: This is my preferred method. My own, personal mindset makes it difficult to constantly aim for big winners, especially when that involves the inevitable 20% correction in leading stocks.
Of course, the above four methods are just the tip of the iceberg—you can delve into a mixture of averaging up and selling on the way up, you can vary position sizes, and so on. But giving some thought to these portfolio management strategies today will do just as much for you as finding the next hot stock.
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