Ride Your Winners, Dump Your Losers

Ride Your Winners, Dump Your Losers

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Assume that you have invested into two stocks - Stock A and Stock B. You made 50% on Stock A and lost 50% on Stock B. If you need to liquidate one stock to get some cash, which stock would you sell? It is human nature for people to take profits on Stock A and keep the losing trade until Stock B rebounds. Chances are Stock A is so wonderful that it will keep going up after you sold, and Stock B will keep going down and your loss becomes bigger. The bigger your loss, the more reluctant you are to sell and eventually you will end up with a bunch of losers.


Ride Your Winners

Momentum Trading

According to the “Ride Your Winners, Dump Your Losers” theory, if you manage to fight off your human nature and keep the winners instead of the losers, you will make money. This seems to fit in well with the theory of momentum trading – buy the strongest stocks with the highest momentum, i.e. the stocks that are increasing quickly on higher volume than the market. Disciplined momentum traders would buy with the flow of the market, if a trade goes against them, they would sell without hesitation. They follow the market trend with no question ask.

As the theory goes, you should not be emotionally attached to your trade. If you have invested in a dud, you should just admit your mistake and cut the loss. This theory sounds credible and sensible.


Value Investing

This theory may make sense for a short-term momentum trader, but it certainly does not make sense for a long-term value investor. Assuming that you have done your homework and the two stocks were the same valuation at the time of investment, the fact that Stock A has gone up and Stock B has gone down means that Stock A is now far more expensive than Stock B. A prudent value investor would switch out of the expensive Stock A and switch into the much better valued Stock B, provided the fundamentals of the two stocks have not changed.

Instead of blindly selling the losers until all you have are winners, you should really look at whether the fundamentals have changed for the stocks. There may indeed be a good reason for the relative underperformance of Stock B – e.g. poor management or grim industry outlook. However if nothing has changed and you thought Stock B was good value when you first bought it, it must be an absolute bargain after dropping an extra 50%! Shouldn’t you be buying more instead of selling?


Winners Always Outperform Losers?

The key question in deciding whether this is a valid theory is whether winners are more likely to outperform the losers? If that is the case, the same group of winners should always dominate the world economy. Taking the component stocks of the Dow Jones Industrial as examples, which are the winners of the winners. Do these blue chip winners always outperform the market? Looking at the original dozen component stocks of the Dow in 1896:

American Sugar Now Domino Foods, Inc., part of Sweden’s Assa Abloy
American Cotton Oil Now Bestfoods, part of Unilever
North American Company Electric company broken up in the 1940s
Chicago Gas
Now a subsidiary of Integrys Energy Group, Inc
Laclede Gas Still in operation as The Laclede Group
National Lead Now NL Industries
Tennessee Coal & Iron Swallowed by U.S. Steel
American Tobacco Broken up into Fortune Brands and R.J. Reynolds
Distilling & Cattle Feeding Predecessor of Millennium Chemical, part of LyondellBasell
U.S. Leather Liquidated in 1952
U.S. Rubber Company Merged with B.F. Goodrich, now part of Michelin
General Electric Only one that is still around

The only company that you may still recognize is General Electric (even General Electric has been dropped from the Dow for 9 years). The rests have either been taken over or wound up. Had your great great grandpa set up a family trust to invest in these winners 100 years ago, there would probably not be a lot inheritance left for you.

In fact, some academics have noticed the opposite effect - “the small stock anomaly”. For example, Rolf W. Banz has shown that smaller companies (which tend to include a lot of “losers”) from 1926 to 1980 outperformed the larger companies.


The Winner Takes It All



It Really Comes Down to Your Trading Style

Ultimately it really depends on your trading style. If you are a momentum trader that trade purely on the basis of a surge in price and high trading volume, it is wise to scramble for the exit when the stock loses its momentum. However if you have picked the stock on the basis of its valuation, the fact that it drops more means it is even better value – time to buy more instead of sell. Obviously if the fundamentals (future prospects and changing sector conditions) of the company have deteriorated, you may need to admit your mistake and sell.

This theory sounds more credible than it really is in countering the human tendency to keep the losers. The fact that it identifies a stock as a winner or loser on the basis of the entry price already introduces an element of subjectivity. An emotion free investor would only look objectively at the fundamentals and the valuation of the stock, instead of getting hung up on the entry price.