“Cut your losses short and let your winners run.”      The Golden Rule for Traders

This strategy of not to stay in a losing position too long and, on the other side, not close a winning position too soon is often used by experienced traders. You want to be quick with losses and patient with profits.

In behavioural finance research, one of the most prevailing biases is the tendency to hold losing stocks longer than winning stocks, or “let their losers run and cut their winners short”. This is called the disposition effect, due to the “fear of regret”.

Selling a losing stock is tantamount to admitting that one was wrong, and feeling wrong inspires painful regret. To avoid regret, investors hold on to losing stocks while hoping for a comeback that will vindicate their initial buy decision. On the other hand, they sell winning stocks too soon for the fear that the stock will drop, giving back their gains, and they will regret not having taken their paper profits off the table while they had the chance.

I would think that this strategy of "cut your losses short and let your winners run" is absolutely essential for traders as traders mainly look at the price and volume actions in the market place, aiming for quick profit, and not so much about the fundamentals of businesses they put their money in. They hate to have to wait for three years, or even three months. Day traders even can’t wait for a day!

If they are wrong in a trade, often can be very wrong because they basically depend on the greater fool theory; you buy, I buy, you sell, I sell. Why? I don’t care. Hence cutting loss is a must to limit losses. And yes, the winning can be very big, and it is a good strategy to ride on the winners. It is not necessary to bother about the fundamentals too.

But how many traders actually made money using this trading strategy? What are the statistical evidences available showing the success of this strategy. You can do your research on it as there are plenty of resources and research available in the internet.

For my own experience in early 2000, I did let my remisier the freedom to handle my investment with this strategy as he introduced to me. The results were not encouraging. Here, we will not deal with it. I would be happy if other traders can share their experience here.

As I am a fundamental investor, I will discuss this from my own experience in fundamental investing if this strategy of “cut your losses short and let your winners run” is useful for me.

I will address these two questions:

1. Should I continue to ride on winners, or buy more even though they appear overvalued?
2. Should I cut loss?

My investment philosophy and strategies

My philosophy of investing follows that of Warren Buffet, i.e. to observe his two important investing rules;

Rule No. 1, don’t lose money (at least try),

Rule no. 2, don’t forget Rule No. 1.

With those rules, I generally have two major investment strategies which I have been harping on all this while;

1. the Magic Formula of Greenblatt; buying good companies on the cheap, and
2. the Graham Net Current Asset Value (NCAV), and the negative enterprise value; buying quality assets on the cheap

For those who are interested what they are can refer to this link below:

http://klse.i3investor.com/blogs/kcchongnz/56884.jsp

Of course these strategies are based on the past performance of companies. As I am just a small time retail investor, not a professional analyst, nor an investment bankers, what else can I base on, Paul the Octopus? Mind you, professional analysts and investment bankers on average are wrong about predicting the future most of the time, and often very wrong, as research has shown unambiguously.

Stocks in my portfolios

Table 1 and Table 2 in the Appendix shows the stocks I have selected for the two stocks selection contests organized by Tan KW, another i3investor forumer in 2013. The investment thesis and detail reports of those selections can be viewed from the following links:

The first portfolio set up on 23^rd January 2013 as shown in Table 1 in Appendix is here:

http://klse.i3investor.com/servlets/pfs/13147.jsp

As at to date, the return of the portfolio is 127.3% compared to the 6.5% of KLCI.

And the second one set up on 1^st August 2013 as in Table 2 with the total returns of individual stocks.

http://klse.i3investor.com/blogs/kcchongnz/68009.jsp

The return of the portfolio is 113.3% compared to the drop of 1.9% of the broad market.

As you can see from both the portfolios, there are a number of stocks which have risen for more than 100% in less than 3 years of holding period; Datasonic, 570.8%, Prestariang, 442%, SKP Resources, 367.7%, Homeritz, 361%, Pintaras 180%, and Fibon 108.1%.

Let us for discussion purpose, take a few stocks from there to discuss here if one should have kept those stocks until now, or should have sold them when they have reached their intrinsic values, and what would have been the results of each action.

SKP Resources in My First Portfolio

About six years ago, you can purchase 100,000 shares of SKP Resources for RM4500 at an adjusted price of 4.5 sen per share. If you have kept the shares for 3 years, you could sell them for RM34000 at about 34 sen a share, or for a gain of 656%.  

The share price of SKP Resources stayed at around that price, i.e. 34 sen for another three years until the beginning of 2014. I started invest in it somewhere at that time and I remembered, the fundamentals of SKPR was very strong and it was selling cheap. That was why I have included it as a stock in my first portfolio.

And how many investors who have bought it at 34 sen at the beginning of 2012 held it for 3 years without any movement of its share price? How many speculators were willing to wait “left of three years and right for three years”? I guess very few.

SKP Resources share price shot straight up from 34 sen from then on to RM1.52 within one and a half year at the end of July 2015 as shown in Figure 1 below. The gain from there was 347%! The RM34000 invested in 100000 shares of SKPR has become RM152000. For those who have invested in it during early 2009 would have made 2071%, just in 6 years!

How many investors let the winner runs and have kept the shares for so long? I have to admit that I am not one of them as when its share price doubled from 34 sen to 68 sen in October 2014, it appeared that SKPR was already overvalued.

Letting your winner runs would have made an investors very well investing in SKP Resources as shown.

Let us look at another share which is in My Second Portfolio as shown in the Appendix, Datasonic.

Datasonic, the supersonic

Datasonic caught my attention in mid-2013. At that time, its share price was about RM3.00, or at an adjusted share price of about 24 sen, with all the bonus issues and share split. At that time, it share price has already risen by 220% in less than a year ago.

Soon after that the share price shot up by 870% in 7 months from 24 sen to RM2.33 on 2^nd April 2014, before retreating to half its peak price to RM1.03 in 6 months on 4/12/2014!

At the close at RM1.57 on 18^th November 2015, if I have kept my shares until now, my gain is still a whopping 554%, in less than 2 years, even after the steep drop in early April this year!

Those who have time the market right by selling of at the peak of RM2.33 would have laughed all the way to the banks. But just wonder how many have done that?

For those who chased the shares when it was at its peak would still suffer a big loss of 33%.

Let us look at another one in My First Portfolio, Prestariang.

Prestariang

Prestaring first caught my attention when it was selling at an adjusted price of about 50 sen in mid-2013. Its price has in fact stayed at around that since listing about a year ago as shown in Figure 3 below. It had fantastic fundamentals in terms of very high returns on capitals, and abundant cash flows. Its dividend yield then was very attractive too. At 50 sen then, it was a real steal!

Prestariang’s share price shot up suddenly to RM2.30 within a year for a gain of 360%. Most investors would have sold it of for a handsome gain by then, and felt happy when its share price retreated by 40% in mid-December 2014 when the bear strikes. Little did they know that it jumped again to a close of RM2.60 on 18^th November 2015.

How many investors managed to invest at its trough at 50 sen 2 years ago, sold at its peak at RM2.30 a year later, and bought back 6 months later and hold it until now and make tons of money? I believe there is none.

Lessons taught on “Let the winner runs”

Most fundamental investors who make their sell decision based on business valuation would have missed out the continued uptrend of the stock prices above, unaware with the investing maxim of “Let the winner runs”.

This brings to the subject that, investing is not an easy thing. Theoretically, all investments are for sale for the right price. Practically though, it's very hard to know what a stock is truly worth. Fundamental investors make their "sell" decisions based on "overvalued" criteria which is a difficult subject. Consider these points:

• Company value is subjective, it depends on who is valuing it, what are the assumptions, and for what purpose. Value, like beauty, is in the eye of the beholder;
• Value is vague - it's not a precise static number, it's a constantly changing range based on "educated assumptions" about the uncertain, unknowable and ever-changing future;
• Under-valuation is easier to identify because there is an objective floor (liquidation value). Over-valuation, on the other hand, is far less certain - there is no clear ceiling;
• Over-valuation is also a range, data and assumptions will play out differently for different people.

Naturally, as over-valuation increases, it becomes more obvious, and the decision to sell becomes easier. The problem is - where do you draw the line? How "over" should be overvaluation?
 

The above example of stocks in my portfolios have shown why one should not sell stocks of good companies for the reasons below.

1. Great companies are rare and very hard to find and get in
2. Once you sell a long-term investment, you are leaving a business you know well.
3. You are leading yourself to a reinvestment risk, what other better businesses you can buy and confident about with the proceeds of the sale?
4. One of the worst things that can happen to a long-term investor is the loss of perspective and leads you to a speculative mentality. The more you try to exit and re-enter, the more you will think like a speculator and less like a business owner. It might damage your ability to make good long-term investments.

What about cutting loss?

Cutting loss

What would traders do in speculating? As I have mentioned above, it is an essential action to take if one is speculating and trading stocks. If you refer to my “Model stocks’ in the link below, traders who cut loss would have saved a fortune. It is like the difference of becoming a bankrupt, and one who can still survive in this market.

http://klse.i3investor.com/blogs/kcchongnz/67199.jsp

What about cutting loss in fundamental investing?

Well if one looks at the return of the stocks in both portfolios in the Appendix, does he think cutting loss is necessary if one is investing based on a fundamental sound and safe approach?

The biggest loss is Daiman at 11.9%, and the other two out of 21 stocks, Haio at -7.8%, and Kumpulan Fima at -1.4%. The losses are all minimal. They are all in My Second Portfolio which was formed after the run up after the General Election in 2013.

Selecting fundamental stocks based on the principle of investing in great companies at cheap prices doesn’t really need the cut-loss action as shown in the return of stocks in the portfolios. In fact cutting loss can be detrimental to the investing outcome of fundamental investing.

Considering the case of Prestariang as shown in Figure 3 above, most traders would have cut loss when Pretariang fell to 85 sen on 2^nd September 2013, or RM1.70 in Mid-2014, or RM1.30 at mid-December 2014.

Once cut-loss, very few speculators would have bought it back when seeing its prices rises abruptly again and would have missed the boat at the price of RM2.60 now. That is human nature.

Maybe i should say even if we have considered the safe way in fundamental investing, we can still go wrong and cutting loss may be necessary. But the probability in very low, in my opinion.

What to do in fundamental investing on price change?

From the above experience, when we buy stocks, we can add Margin of Safety (MOS) to the conservative end of the estimated fair value range to absorb the impact of uncertainties and mistakes. Similarly, when selling stocks, we can add MOS to the optimistic end of the fair value range, for the same reasons as illustrated in Figure 4 below.

For those who want to know the concept of MOS, please refer here:

http://klse.i3investor.com/blogs/kcchongnz/82758.jsp

Figure 4: Margin of safety when buy and sell stock

This will avoid from selling the winner too soon.

But would I buy more if the prices continue to go up above the upper limit the "Sell" MOS? No, I won't.

“All there is to investing is picking good companies at the right times and staying with them as long as they remain good companies.”      Warren Buffett

Again for those who are interested in the philosophy of fundamental investing and wish to learn the methodologies for stock selection the fundamental way, please contact me for an online investment course for a small fee at

ckc14training2@gmail.com

K C Chong (19^th November 2015)

Appendix

Table 1: Stocks and their returns in my first portfolio

Table 2: Stocks and their returns in my second portfolio