Selling stocks that have declined and stocks that do not rise as expected accomplishes several things. It frees up resources that can be used to buy other stocks more likely to rise in value. It enables your rising stocks to impact your portfolio more fully because declining stocks that would dilute their performance are removed. Finally, it keeps your portfolio more fully committed to rising stocks more of the time. A very simplistic and purely hypothetical mechanical discipline can be used to illustrate the meaning of this article’s title. Let’s suppose that when we invest the outcome is random. Half the time the stock will decline and half the time the stock will rise. Assume also a randomness in the magnitude of stock moves. Finally, assume we have a rule that any stock we buy will be sold if it drops 8% below the highest price attained since purchase.
Even if half the stocks we buy go down and half go up, our system will make money because it will never allow any loss to exceed 8%, and it will leave a rising stock alone until it drops 8% below the highest price it attains after purchase. Thus, if the stock makes a gain of 60% before it declines the allowed limit of 8%, we will lock in a gain of 52%. Profits on a given position have no necessary limits, but a loss can never exceed 8%. In other words, the total gains would exceed the total losses even if stocks moved around in purely random patterns. The discipline used can be even more important to profitability than the ability to be a good stock picker.
Selling stocks that “misbehave” frees up assets that the investor can re-deploy to stocks with greater profit-making potential. It is necessary to control the expenses of the investment enterprise just as an individual would control them in any other business endeavor. The small losses are simply the necessary overhead of running a profitable investment enterprise. Let’s use a merchandising metaphor. The key concept here is inventory control. It is important for a merchant to get rid of inventory that doesn’t move (these items are a drain on resources) in order to free up shelf-space and to have more resources (money) available to buy stock that will move and generate profits. Smart merchants will often sell non-moving inventory at a discount and sometimes at a loss in order to free up resources and shelf space. The merchant considers the loss to be simply one of the costs of doing business (like the costs of electricity, gas, water, rent, salaries, and taxes).
The volatility of the market makes it necessary to be nimble in order to obtain optimum results. Just because taking a loss is not “absolutely necessary” does not mean that holding on to a poor performer to avoid taking the loss is the optimum course of action. When there is a loss shortly after a purchase, it is generally unexpected. That means something has just occurred that has made the stock less desirable. The greater the decline, the greater the probability that something negative has just happened (a geo-political event, FDA decision, court ruling, comment by an officer of the company, achievement of a competitor, or whatever).
Our tests and the experience of our own traders at stockdisciplines.com show that in volatile markets performance is enhanced when stocks are sold while their declines are still small (if their decline is beyond the probability envelope of what is expected for those stocks given their recent price-action and current support levels). Such actions will not always be the most profitable for a particular trade, but we know they will generally produce better results over time. Even though it is not always “absolutely necessary” to sell when a stock falls (perhaps we believe the position will recover in time), we know that better long-term results can be achieved if we do sell and re-deploy the assets.
To maintain a portfolio of winners, you have to keep getting rid of the losers and non-performers. It is like pulling the weeds out of a garden so they don’t choke the growth of desirable plants. Here is the key point: “It is the percentage of time that most of a portfolio is invested in rising stocks that determines how good performance will be.” If losers are left in the portfolio where they can counterbalance the gains of the winners, performance will suffer. The smart trader will want to get rid of the losers so the winners can lift the portfolio. Most people cannot sit in front of their computer all the time the market is open. That’s why it is important to have a good stop-loss strategy. We believe that stops should be ratcheted up as a stock rises. For example, a person could adjust stop orders in the afternoon after the market has closed, in the evening before going to bed, or in the morning before the market opens. If these adjustments cannot be made every day, they should be made at least once a week. By placing a stop order to sell with the broker, an individual doesn’t have to stay “glued” to the screen monitoring stocks. Instead, he or she can forget about the market and take care of other business. Then, if the stock is sold, the sale will be according to a plan carefully conceived in calmer moments.
Copyright 2016, by StockDisciplines.com a.k.a. Stock Disciplines, LLC.
