Trading Rule – Never add to a loser, never dump a winner…

As a trader in the market the natural tendency is to take profits at the slightest opportunity. Unfortunately, there is also a tendency to hold on to losing propositions. In fact, we aggravte matters by adding on to our losing positions. No trader can get it right all the time. The trick therefore lies in holding on long enough to your winning trades and cutting short your losing trades quickly in the market.

WHY DO WE NORMALLY ADD ON TO LOSERS?

Frankly, there is no logical answer to this one. It is that in-built belief that the price of the stock will eventually bounce. But imagine that you had tried averaging on Unitech or RCOM from higher levels. Alternatively, imagine that you had tried averaging L&T or BHEL over the last 9 years. You will still be sitting on losses. Normally, quality stocks tend to bounce on each correction. But what happens when there is a fundamental shift in the stock. In case of L&T, the shift was that the capital investment cycle in India, and around the world, virtually came to a standstill. For example had you started averaging Wipro in the year 2000, you would probably still be sitting on losses. It is this belief that all stocks will bounce back that forces us to hold on or even add to losers in the market.

WHY ARE WE IN A HURRY TO EXIT WINNERS?

This is slightly more complex. When stocks go up, they never go up in a linear fashion. They tend to go up spasmodically in fits and starts. For example, between 2003 and 2008, the Sensex moved from 4000 to 21000. But there were at least 4 occasions, in between, the market corrected by over 20%. When bull markets are interrupted by such frantic corrections, it is very hard to bring yourself to hold on to long positions. It is a natural tendency for us to calculate the notional losses each time the stock corrects. For example, between 2002 and 2007, Crompton Greaves moved all the way from Rs.21 to Rs.1000. In between, there were many sharp corrections. That did not however challenge the much bigger story of revival in capital investment cycle that the stock was betting on. Similarly, between 2009 and 2017 Eicher moved from Rs.200 to Rs.30,000. Imagine that you exited the stock at Rs.400, extremely pleased that you had earned 100% returns. You would have missed out on a million dollar opportunity.

“Always buy on the cannons, but sell on the trumpets” – Old French Proverb

6 REASONS TO EXIT LOSERS AND HOLD ON TO WINNERS

  1. 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.
  1. 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.
  1. 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!
  1. Let us come to the point of holding on to your winning positions. The average star trader also gets only 25-30% of his trading calls bang on target. 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!
  1. 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.
  1. Finally, there is a slight discrepancy. 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.

WHY HOLDING WINNERS AND EXIT LOSERS IS SO IMPORTANT?

At the end of the day, we all trade with finite capital. It is also true that more often than not, you will get your calls on the market wrong. Therefore, the only way you can make money in the market is by cutting your losers quickly and holding your winners long enough. It does not really matter how often you are right and how often you are wrong. What matters is what you do when you are right and what exactly you do when you are wrong. That makes all the difference to your investment performance!

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