Getting out of a trade, especially at a loss, can be an enormously difficult trigger to pull. Equally thorny is simply standing pat and having the patience to let the market move unfold. Yet knowing when to hold ‘em and when to fold ‘em forms the basic framework on which successful portfolio management is built.

Forget Sharpe ratios and exotic options techniques. In trading, there’s nothing new under the sun. The golden rule — cut your losers and let your winners run — hasn’t changed since the beginning of time. And when following up on a trade, that’s precisely the philosophy that you should engage. Winners are preserved. Losers get kicked to the curb. End of story.

I moved quite a bit of money around this summer, so it’s worth following up on some recent columns to best illustrate how, even in this brave new world, the old saws still apply.

While I had high hopes for getting back in the saddle, right now it appears my return to floating-rate funds was a bit premature. Despite their monthly dividends and compelling fundamental story, I must be objective enough to admit that the price action has weakened. Trades that were once green with profit are now bathed in red.

That’s the only indicator I need to prompt me to make a change. Because while the investment hypothesis is still intact, it’s the market that should influence trades. Whether it’s Enron’s implosion or the dollar’s decline, the story almost only comes out after the real move has been made. For now, I’ve once again left most of my positions in this asset class behind.

Of course, taking a loss hurts. And if not approached with the proper perspective, the emotional toil of dealing with a loser can derail an entire investment program. For years, after selling a loser, I’d beat myself up, questioning how I could’ve been so stupid as to buy XYZ right before a precipitous decline. And it’s at those moments, when morale is weakened, that trading discipline can easily go straight down the tubes. Because we want to be right, because we want to win, our ego can’t stand the reality that, at least this time around, we’re wrong.

In a frantic gasp to “get even,” we recklessly double down or start day-trading the Nasdaq 100 (QQQQ) — anything to avoid dealing with the painful reality that we lost money on the trade. Friends, I’ve been down that road, and I promise you that it ends only in even more severe — usually cataclysmic — losses.

So instead of chastising yourself for having a loser, it’s a heck of a lot more productive — and profitable — to simply take the loss, remove the ticker from your trading screen, and move on to another idea. Every wrecked portfolio started with a small loss and a stubborn trader who just had to be right.

While not every trade will be a winner, put enough lures in the water and eventually you’ll get a bite. Thankfully, I’ve had a few, with most of the other ideas I’ve put forth lately having fared much better than the unprofitable foray into floating-rate funds. Gold bullion, which I bought into in August, is up roughly 5%. And of the three recent initial public offerings that I profiled a month back — MarketAxess Holdings (MKTX), Warner Music Group (WMG) and Stonemor Partners (STON) — two are in the winner’s column so far. MarketAxess has climbed 30% since Aug. 22, and Warner is up more than 6%. Stonemor, like the S&P 500 index, has traded flat over the past month.

And how am I following up the winning positions? As a trader, what am I doing to maximize my profit potential? Nothing. I’m doing absolutely nothing at all.

I’m not selling covered calls or scalping around the trades. I’m not taking a quick profit and planning to buy back the positions a few bucks lower. I’m not scouring the message boards or Securities and Exchange Commission filings looking for a reason to jump ship.

The quiet secret of investment success is that too often the best move is no move at all. When you have a winner on, it’s usually just sitting on your hands and having the patience to let a trade run its course that produces the best results.

Yet letting the winners run can be even more difficult than cutting the losers. As traders, we’re anxious to win. We crave success. And there’s nothing as satisfying as taking a position, watching it climb and then making the cash register ring. The feeling puts sex and drugs to shame.

But provided it hasn’t grown to dominate your overall portfolio, the proper way to follow up a winning trade is to let it be. Just as taking a loss stops a loss from growing, taking a profit kills a portfolio’s profit engine right in its tracks. Just consider how many people sold Microsoft (MSFT), Cisco Systems (CSCO), Sun Microsystems (SUNW) or CMGI (CMGI) during their growth spurts because they had made a nice 15% to 20% profit, only to watch the stocks spiral skyward by thousands of percent?

The old lessons are still the best. And after taking a position I follow up by worrying about the losers — usually finding a way to cut them short and move on. The winners I try and leave well enough alone. They tend to take care of themselves.

Investing is a messy affair, with even the best ideas and most well-conceived trades often not working out. Every trader has the occasional loser; the successful ones are those disciplined enough to follow the rules. Clip the losers and allow winning trades to run, and over time you’ll make money. And while both the professional and the amateur know the rules, it’s the pro who actually follows them. That’s precisely what makes him the pro.

– Originally on Sep 26, 2005 by Jonathan Hoenig

The same early-season optimism can be found in the stock market, where a new quarter brings opportunity in both new names and old favorites.

As the wheeling-dealing gets underway, investors should approach every trade with the confidence of Warren Buffett and the wisdom of a blackjack dealer, who knows that even the best players have plenty of losing hands. Although most people want to slap a “time horizon” on their trades, the truth is that the market should decide your holding period, not emotions or research. Every long-term investment starts out the same way — as a short-term trade.

In my view, an appropriately sized initial position is no more than 5% of your overall portfolio. Once you get your trade confirmation, all the analyst reports and newsletter recommendations become moot. As we’ve pointed out in the past, after the first trade is made, it’s all in the follow through. Your job isn’t to research, but react.

Of course, trading can be addictive, and with more than 12,000 public companies, there’s never a shortage of intriguing investment ideas. Indeed, it’s human nature to want to tinker with your portfolio. And because the grass is always greener on the other side (or in another stock), too often we sell winning positions way too early, opting for a small profit and the exciting chance to go out for another “big kill.”

I never go into a trade with a set “time horizon” of how long I plan to hold on. If the stock moves against me, I could be out in a day or less. But as long as it’s going my way, I do my best to stay in the position. When the trend is your friend, remain a committed holder, even through the occasional hiccup, sell-off or mild slump. Although we operate on a rigid schedule of news cycles, trading hours and quarterly reports, the market is on nobody’s timetable but its own.

Unfortunately, patience is in decidedly short supply. They want the market to function like some type of infinite cash machine. Just stick in your card and watch the hundreds tumble out.

But the big moves don’t happen over minutes, but months. So the duration of any one particular trade shouldn’t be a function of the psychological need for a “win” but rather the stock’s price action. Without a doubt, the best traders work around the market’s schedule, not their own. They know that just because they have gains doesn’t mean they should take them. Instead, investors should think of “taking” as another word for “stopping.” Take a loss and you’ve stopped it from growing. Take a gain and you’ve stopped the exact reason you got in XYZ in the first place.

The main reason to consider selling a stock is that it has grown to dominate your entire portfolio, making it uncomfortably volatile. Another reason, and the most common, to consider selling a stock is that its decline in price begins to have a major impact on your bottom line. While past performance isn’t a guarantee of future result, it tends to be a pretty good indicator nonetheless. Weak stocks are weak for a reason. Let them be.

But oftentimes a stock will rise sharply and then consolidate for a period of months or more. How do you know if should you keep it for the long term, or simply take the money and run?

Like most aspects of trading, it comes down to efficient asset allocation. While you usually can afford to wait on a position, holding out for an entire portfolio is a recipe for disaster, as many former technophiles can attest. So when one of my major holdings turns from hot to not, I’ll reduce my exposure — but I won’t eliminate it altogether. Like a wall full of trophy taxidermies, you’ll want to keep at least a piece of the trade in your portfolio for as long as possible. Winning positions tend to continue to grow over time, even after the initial growth spurt. Keeping a position in a winning trade is a prudent move.

Ultimately, the market, not the pundits, analysts or experts, will decide when it’s time for you to sell. While we do our research and invest accordingly, nobody knows what will ultimately happen. Predicting the future is impossible — but anticipating it in a rational way isn’t.

Because a big part of trading is not trading, you’ll need a few nonmarket activities to keep your finger out of the fudge pot. Video games, eBay and Funbets.com are among the no-stakes distractions that keep me busy when I’m tempted to sell too early. If that doesn’t work, try setting a series of trailing stops and simply turn off your computer screen. Let your broker do the dirty work for you.

In the final analysis, stop orders tend to be the best approach, because the market is going wherever it damn well pleases, whether or not we watch its every move. And if you focus on cutting losses, the gains tend to take care of themselves.

– Originally on Apr 01, 2002 by Jonathan Hoenig

Life springs up in the strangest of places, and a trading idea is no different. It might come from a fully formed and well-researched hypothesis or on a completely impulsive whim. A trade can be inspired by a personal experience or an emotionless stock screen. It might add to your portfolio’s volatility, or reduce it.

Remember, though, that an oak tree drops thousands of acorns, but only a tiny fraction will ever sprout. And so it goes with building a portfolio. Because nobody can be right all the time, you must scatter your seed far and wide. So find a standard trading unit — somewhere between 2% and 5% of your portfolio, and stick with it. Get used to putting on trades that grow into oak trees, not starting with oaks that may shrivel back into acorns.

When a trade is young and foundering and looking for direction there’s not much we can do for it. And just as every toddler could one day grow up to be president, so does every trade carry the possibility of being the next big thing.

Of course, most won’t be. In fact, the overwhelming majority of my trades go nowhere special at all. Having losing trades does not by definition make you a bad trader. And if you can’t learn to accept this simple fact of life, then buy an actively managed mutual fund and call it a day.

For those few bets that do pay off, you’ll inevitably find that a small trade quickly grows into a substantial position. Think of it as your position entering adolescence: Whether you’re adding to the trade or just patiently watching it grow, a winning trade will often have astonishing growth spurts in short periods of time.

As a position grows, it will by definition become a larger part of your portfolio. And although you might be salivating at the thought of a lay-up profit in such short order, resist the temptation to make the cash register ring as soon as a stock surges. Just as good parents recognize that a teenager needs more autonomy and responsibility, you can only profit on a stock’s longer-term trend if you don’t stand in its way.

Eventually, of course, that teenager grows up, his eyesight deteriorates, his pate goes bald and his waistline expands. And there comes a time when trades, too, begin to feel their age. Nevermind the long haul. The truth is that a stock’s main period of significant, rapid price appreciation is often confined to a relatively short span of time. Motorola (MOT) and Dell Computer (DELL) are two prime examples of stocks that grew up in the 1990s and should probably have long since been retired from your portfolio. Even Warren Buffett, who’s known for never selling a stock, recently put his Citigroup (C) stake out to pasture.

Within your portfolio, you know a position has matured once a decline or stagnation in its price begins to have a meaningfully detrimental impact on your overall bottom line. But just because a stock isn’t as spry as it once was doesn’t mean it’s time to put it on an ice floe and push it out to sea. When one of my positions begins to falter, I set a schedule of sell stop orders that will reduce my exposure should the stock continue to fall. So if my 500-share position of XYZ falls from 60 to 50, I might set orders to sell 100 shares of stock every two points down. The weaker the stock becomes, the less my portfolio is exposed. I protect my upside, but also my profit.

Your profit is your oxygen. There’s nothing more important than ensuring a smooth, steady supply. So on those fortunate occasions where you’re able to make some money, you must be very particular about how those proceeds are spent. How you reinvest your capital is almost as important as how you deploy it in the first place.

As we’ve discussed before, a percentage of any score must immediately be segregated to cover the unavoidable tax bite that goes along with any capital gain. I’m also of the school that says some of your profits should be spent. Making money isn’t easy, and buying even a small something for yourself is the best way to remind us of what makes money worth working for.

The remainder should be reinvested into your most promising new ideas — but not the way most people do it.

Fresh on the heels of a speculative win, they’ll usually plunge straight into another stock pick. Indeed, on the heels of a big score, most people find it quite tempting to “switch” — that is, to immediately plow the entire proceeds of one winning trade into the next hopeful contestant. So if they sell $10,000 worth of Wal-Mart Stores (WMT), many people simply buy $10,000 of Gap (GPS) or Sun Microsystems (SUNW) or whatever their fancy happens to be at the moment.

But just as an oak tree scatters many acorns, a winning trade should serve to fund any number of new promising ideas. New positions should start with your standard trading size. Assuming the 3% portfolio allocation to each new trade, selling a 12% position should yield at least four new trades. Over time, you’ll find that, on average, one will be a stinker and two might go nowhere at all. The fourth will be another oak tree, yielding another harvest of acorns, ready to be planted in whatever you consider to be the most fertile soil at that time.

– Originally on Feb 25, 2002 by Jonathan Hoenig

What saves me, however, is that the profits from my winning trades are bigger than the losses from my losing ones.

Simply put, you don’t have to win more often than you lose. You do, however, need to win bigger than you lose. I have found that when it comes to allocating a portfolio, the old “80-20″ rule tends to apply: 80% of your profits tend to come from 20% of your trades. To that end, the point isn’t to search for trades with a high probability of winning, but with a high probability of a large return.

Returns, large or otherwise, are few and far between these days. A vast majority of mutual funds lost money in the first half of 2001, and after another couple of bruising months in the market, it isn’t a surprise that most people aren’t looking to take on major risk. Listen to the vox populi these days and you’ll find dividends are very much back in vogue. Bonds and “defensive” sectors, like pharmaceuticals for example, are all the rage. These are just a few of the once-boring investments that are now seen as safe moves for precarious times.

But the notion of safe stocks is a misnomer, because if you’re trading stocks, then the truth is that you want to seek out high-risk situations. After all, that’s where the payoff is. As a trader, your job isn’t to avoid risk, but to manage it. (Let’s get one thing straight, though. I’m talking here about risk capital, which is the only kind you should be trading with. There’s a vehicle that pays out consistent, safe returns, and it’s called savings.)

Being naturally risk averse, however — and even more so in recent months — most people place their wagers on the seemingly safe favorites. Sounds reasonable, right? Indeed, most people feel confident knowing that their money is riding on the stock with the best odds…i.e., the best chance of “winning.”

And although we often interpret odds as probabilities, the reality of markets is that anything could happen. Whether posted in the Racing Form or in a pundit’s research report, odds don’t tell you what horse is going to finish the race first, nor what stock is going to move higher. Over short time periods, a “risky” stock has just as much chance of paying off as a “safe” one, especially when the risky stock is showing some sort of technical strength. Sometimes the long shot wins, or the public favorite falls. Trading is just like life — anything can happen.

Odds simply reflect the payoff schedule of a particular event at a particular time. Less probable outcomes are given more attractive (read: lucrative) odds. So assuming you’re using appropriate position size, the actual risk in buying either the “risky” or “safe” stock is actually quite similar. Consider the horse-racing example: Whether you put down a $2 bet on the long shot or a $2 bet on the sure thing, the risk is still $2. What’s different, of course, is the payoff schedules dictated by the odds. Horses with “good odds” might pay one to two, or $1 for every $2 bet. Long shots, the track’s version of “risky” stocks, might pay 30 to one, or $30 for every $1 bet, an exponentially better payoff.

This is precisely the problem with betting the favorites. Good odds, by definition, mean lousy payoffs.

Sticking to “safe” bets is actually a recipe for underperformance, because tiny payoffs don’t compensate for the inevitable losses that go along with any type of speculative endeavor. The truth is that what most people think of as good odds are actually lousy odds. In reality, the stock that’s perceived to be “safe” has all of the downside of a “risky” stock with a fraction of the upside.

So instead of focusing on making winning trades more numerous, try and make them more profitable. Think like a mom-and-pop store: high margin, low volume. “Risky” stocks, such as those based in emerging markets, biotechnology or junk bonds, are highly volatile, but it doesn’t mean they should be excluded from even supposedly “safe” portfolios. As with most elements of trading, success comes down to proper technique.

Most people don’t assume risk — they manufacture it. For example, they don’t just buy a closed-end fund that focuses on emerging markets, they put 25% of their portfolio in at one price, on one day, and without the benefit of a well-defined trend or a diversified portfolio. That isn’t risk — it’s recklessness.

“Safe” trading isn’t about avoiding risk, but managing it. We can’t control the market, but we can control the size, timing and types of bets we make. And while it may be psychologically comforting to bet with the crowd, real payoffs come not from continually playing the favorites, but from playing the field.

– Originally on Oct 29, 2001 by Jonathan Hoenig