September 22nd, 2006
“Bulls make money, bears make money but pigs get slaughtered.” Everyone has heard this trading “rule” and, yet, it’s still insufficient to give any guidance on one of the most difficult challenges for anyone playing the market and that’s deciding when to sell.
My wife (who happens to be a pretty good stock selector and trader in her own right) and I continually debate this question. She subscribes to a service that suggests selling half a position when predetermined profit targets are met. Cramer answered a caller’s question last night with his familiar refrain that the caller, who had a significant profit on a particular stock, should “schnitzel a little and take some money off the table while leaving the rest to play with the house’s money”.
Well, I’m sorry, I just don’t get it. While I see this solution may resolve some of the anxiety issues for either the investor or the individual who recommended the stock (like Cramer or Gorilla Trades), it makes seem to me to be based on sound financial sense. While the strategy may be a compromise with regard to individual stocks it ignores, and only complicates, an investor’s portfolio management challenge. It leaves unanswered and raises many other questions, like:
- When to sell the remaining 50%?
- While selling 50% after making predetermined profit targets locks in portions of individual stocks’ gains, wouldn’t it ultimately lead to too many small positions in the portfolio?
- It doesn’t recognize sector rotation issues?
- It fails to acknowledge over-all market direction?
- What about tax consequences?
- Even though commissions are now highly competitive, what about transaction costs?
A decision to hold on to a stock (or a remaining 50% position) is equivalent to buying those shares at that moment. Every day, whether you’re considering purchase of the shares, already own the stock or own only the remaining 50%, you are making a real-time decision by asking yourself the question: “how do the prospects for that stock compare against others in the stock universe (or cash)”.
With everything else being held constant (that is, the over-all market and individual sector performance remain favorable), a stock in motion usually stays in motion. It’s hard enough finding true winners (stocks that have positive relative strength, go up 50% or, if your lucky, even over 100%) so when you find one your overall portfolio performance improves by holding on to it than by selling all or a portion of it and trying to find another winner to put the proceeds into.
The S&P 500 has increased 5.59% year-to-date. Of the 6865 stocks in my database service (Worden Bros. Telechart), less than half (3013 or 43%) have increases greater than the S&P index. If, hypothetically, your portfolio consisted only of those stocks, you would have beaten this benchmark. But should you then automatically, today, sell half these positions and put the funds into any of the remain remaining 57%, or 3852 stocks? It makes no sense to me.
What does make sense if to hold on to winners until 1) the market turns down 2) the sector loses steam (like housing, oil and gas or metals recently) 3) there’s disruptive news (like accounting scandal, significant lawsuit, etc.) on the individual stock or 4) other stocks in the industry out-perform and you want to rebalance the portfolio or 5) the stock is clearly forming an extended topping chart formation.
Take, for example, Danon (DA):
The stock (ADRs, that is) began trading at the end of 1997 and began forming what we now see as an ascending triangle. The upper resistance trendline of that triangle was breached at the end of 2003. Purchasing the shares at that time would have been disappointing because it took nearly a year for the stock to retest the support at the trendline before it really began to move up. Over the past 24 months the stock has nearly doubled. Since then, there have been 3 significant retracements but no clear top formation has ever formed. The stock withstood the tech bubble burst and 9/11, market corrections and downturns, sector rotation.
Following the “pigs get slaughtered” philosophy (or one who uses trailing stop losses), an investor who purchased the stock on the initial breakout probably been sold out at any of those retracements with a new challenge of finding a place to park those funds. Because of the length of the base formation (6 years!), DA is a stock where selling 50% of a position would have been absolutely the wrong move.
It takes strong discipline and patience (more than I have, I confess) to only buy stocks after breakouts from long base formations, hold them through the retesting and intermediate corrections, and sell only after the formation of almost an equally long top formation. But that’s the way out-perform the benchmarks.