InvestorQ : What is the reason we must cut losers and hang on to winning stocks?
Moii Chavate made post

What is the reason we must cut losers and hang on to winning stocks?

Dia Deshpande answered.
3 years ago

When we talk of winners, we are not only talking about returns but also about potential. The best of stocks give fantastic returns if held on for a long time. There are umpteen examples. Let us understand this point in greater detail.

Firstly, by holding on to losers, you lose out on other trading opportunities. Remember, money has an opportunity cost. If you buy a stock closer to its high and hold through the downtrend, you miss out on scores of other stocks that could have outperformed. Above all, avoid averaging your position. When you bought a stock and the price went down, it means you were wrong in the first place. By averaging your position, you are only being twice wrong knowingly.

Secondly, averaging is a bad idea because it distorts your asset mix in a way that is against your own intent. There is a big concentration risk that you run when you keep averaging your position. If you bought a stock at Rs.100 and the stock went down to Rs.80, the normal tendency is to average the stock. That may bring down your average cost to Rs.90 but in the process you are increasing the proportion of that stock in your overall portfolio. Try to expand this logic to sectors and themes. If you persist on averaging your positions, then you may end up being excessively exposed to a particular industry or theme and your entire portfolio performance may become contingent on that one factor. That is too much of a concentration risk.

Thirdly, when the price of a stock falls, it probably is sending out a very important signal. When Kingfisher stock started falling, the problems of liquidity and defaults were already well known. Yet people kept buying or holding on to the stock in the hope that it would bounce. Eventually, the company folded and the stock became worthless Listen to the market signals keenly! By averaging we end up treating cheese and chalk in the same manner. Buying a stock just because it is falling is a bad idea because we are then ignoring the message the market is trying to send across.

Having understood the need to cut losing positions, let us come to the point of holding on to your winning positions. The average star trader also gets only 35-40% of his trading calls bang on target. We are talking of the best of traders and not the average trader on the street. If you keep booking early profits on your winning positions then you will never be able to earn enough to compensate for the risks of stop losses and bad calls. Remember the case of Eicher Motors! Instead of jumping in and out of a stock, as well hold on to it for the long term at least as long there is earnings visibility in the stock.

We all talk of long term but few of us really act long term or think long term. Equities always create value in the long run. But for that it is very important that you hold on to stocks long enough and more importantly you hold on to the right stocks. Remember, behind every stock that is a company so try to understand the company. Has the company build any entry barriers; has it some disruptive product or idea; does the company enjoy inordinately high margins, growth or ROE? These questions can help you decide when to hold on to winning trades. If the company is seen to be creating long term value or if it is grossly disrupting the industry then you can always hold on for much longer. Jumping in and out is expensive and not tax smart. Of course, beware the trap of cyclicals but there are enough stocks going around in the market that are worthy players.

Lastly, there appears to be confusion among many investors. On the one hand we keep telling about keeping liquidity available and on the other hand we ask investors to hold on for the very long run. Where is the trade-off? How do you reconcile the need to stay liquid with the need to hold on to your winning positions? The answer lies in trailing stop profits or rolling stop losses. The stop loss at a point transforms into a stop profits, which becomes your worst case protection. That is an effective way to balance these two contraries.