Elm Wealth: A Closer Look at “Cut Your Losses Early; Let Your Profits Run”
Most traders follow a mantra of getting out of a losing trade quickly. That can avoid the permanent impairment of capital, and keep losses small.
The follow-up to that concept is to let a winner ride. Taking a rallying stock out of a portfolio reduces the number of stocks moving up in a portfolio. And for a great company, it can mean leaving one of the best potential winners of an investment lifetime on the sidelines.
While this general advice is followed by professional traders, academics have a different view. If stocks follow a “random walk” and their daily moves aren’t part of a larger trend, then the advice makes little sense.
However, data looking at investing just in a market index versus Treasury bills indicates that investors may want to cut losses early. Such a portfolio outperformed the market by an extra 1.4 percent annually.
Plus, during some of the market’s worst drops, the strategy reduced the total losses by half. That includes the 1929-1932 crash, and the 2007-2009 drop.
The strategy holds up across different asset classes and different time periods.
Investors who still stick with a buy-and-hold approach may want to rethink their strategy. They could get back to profitability more quickly and compound a higher return over time. While some assets may be thought of as a hold forever, that policy should only be preserved for stocks that can continue higher.