FOR MANY PUNDITS, investment tips exist in a fantasy world with no capital constraints, margin limits or time horizons. Because pundits focus on stocks picks, and not portfolio management, most of their work centers on where to put new money rather than how to deal with existing positions.
So while in a perfect world we’d always have a clean slate to work with, in the real world most of us travel with baggage. And in your portfolio, that boils down to existing positions. As we’ve written before, that’s always the starting point for smart financial decisions. More than anything else, your existing positions should influence how you invest. Since it’s always preferable to maximize an existing position rather than open a new one, I suggest looking at what’s already happening within a portfolio instead of focusing on what might happen in the market.
The best way to begin evaluating a position is to determine whether you own it as a gain or a loss. But use caution: It’s at this initial step that many investors’ discipline goes horribly awry. Why? Because people tend to get rid of stocks that have made money, yet hold on to shares that have gone down the drain.
The hardest thing about trading is often sitting on your hands. To that end, often the best way to maximize a winning position is to let it be. No covered-call writing. No fancy intraday swing trading. No shorting-against-the-box option strategies. When you have a winning position, just try your darndest to stay out of its way. The market doesn’t know where you bought it, and although nothing feels as good a taking a profit, you can’t maximize your winning trades if you’re always nipping them in the bud.
Even if a winning position has grown so large that a portfolio’s diversification is compromised, I still don’t advocate arbitrary selling. So if you have a big winner on your hands, don’t just toss it out. To maximize the position, use stop-loss orders underneath the current price of the stock, and let the market, not your judgment, guide your sales. This deters a single ill-timed trade from limiting profits. And no matter what, don’t sell a share more than necessary.
With winning trades, we maximize our positions by trying to stay in them. Losing trades, however, aren’t generally given the benefit of the doubt. The truth is, when it comes to portfolio management, if you worry about the losses, the profits take care of themselves. I spend most of my time looking at stocks in my portfolio that have declined and figuring out the best way to make the best of an admittedly bad situation.
Not every stock is a winner. And one of the most productive ways to maximize a losing position is to learn from it. You lost money on XYZ. Fine. But as we often suggest, what often hangs traders isn’t the market — it’s their own poor technique.
So as painful as it might be, analyze the trade and try to understand just what went wrong. Were you trading too big? Did you get stupid and double-down? Was XYZ part of a well-thought-out strategy or just a poorly planned lottery ticket? Dealing with losses hurts — and it should. The more you dislike that pain, the better you’ll be at avoiding it.
Another way to maximize a losing position is to analyze it within the context of the current market environment, perhaps making a case for keeping it. As we often like to point out, trading is first and foremost an exercise in observation. So contrast what’s going on in your portfolio to what’s currently happening in the market. If an old position (or group to which that position belongs) is showing new life, I’m more likely to hold the loss or tax-swap it into a similar type of security, trying to turn lemons into lemonade. Instead of always looking for new positions, it’s always more advantageous to try and maximize the ones you already have.
For example, say you bought gold a few months back and are now sitting on a losing position. A sharp eye would note that despite still being down from the peaks a few months ago, gold has once again strengthened in the last several weeks. So rather than selling into a market’s strength, I’d respect it. And while I wouldn’t pour more assets into a losing trade, I’m able to justify holding on to one that’s proving to be a timely pick in the current market. The trick is to be able to hold the position without necessarily adding to it. And if XYZ strengthens to the point at which you’d buy it as a new position, then you’re already one step ahead of yourself.
And finally, because losing trades do tend to stay losing trades, the best way to maximize an underwater position is to set a plan for getting out of it. Big losses start out as small ones, and no matter how good the story is, the sure method of handling a losing trade is to throw in the towel. The art lies in the technique. So instead of just arbitrarily selling losers, I try and maximize my position and “trade out of them.” This is accomplished by setting stop-loss levels below the current market price at which you will sell a portion, if not all, of your losing position.
Even though I’ve ridden XYZ from $50 to $45, I won’t necessarily dump the stock at $45. What I will do, however, is to set an exit strategy by establishing stop-loss orders to sell somewhere in the $44, $43 or $42 region. And while we’re always fearful of “selling the low” and missing out on the big rebound, I’d rather get stopped-out than hold vigil over a losing position that might go nowhere for years. The point is that you liked it at $50, not $45. If XYZ ever gets back up there, then you can always buy it back.
The reason to use stop-loss orders below the current market price is that while losing positions tend to stay losing positions, the fact is we never really know for sure. A stop-loss order gives the stock a small amount of wiggle room in which it can potentially show some strength. As we’ve discussed before, as the stock moves higher, so should your stops. Should the stock continue to decline, you’ve already limited your risk, and because the order is placed in advance of the price being traded, you’re first in line to get out.
Because the market is always unknown, even the best traders can’t always predict what’s going to happen. And because we’re not just trading stocks, but rather positions within a portfolio, the trick isn’t always to find winning names; it’s to maximize the ones we’ve already got. By taking a skillful approach to both the winners and the losers, profitable trades are preserved to grow, while the inevitable losers are cut off, or at the very least, controlled.
– Originally on May 12, 2003 by Jonathan Hoenig
