When it comes time to prune your portfolio, the first stocks you should consider selling are your losers. There are the obvious tax advantages of doing so. But even more important is the likelihood that losing stocks will stay losing stocks. Very seldom does one of my holdings come back from the grave.

But what about selling your winners? You might have some. Although the major averages are under water year-to-date, there are actually plenty of stocks that are doing quite well.

So if you are fortunate enough to be sitting on some winners these days, how do you know when it’s time to take the money and run, as Steve Miller puts it? What is the smartest way to turn a paper profit into the real thing?

The “experts” will tell you to monitor a company’s economic fundamentals. That you should sell when management changes or when earnings begin to decline. The only problem is that by the time that information becomes public, the stock has usually more than anticipated the news. Stocks don’t move in response to news, but in advance of it.

For example, a good time to think about getting short Cisco Systems (CSCO) would have been back in August of last year, when the company reported an incredible 61% jump in revenue. For those looking to get long the stock, buying soon after the company finally disclosed how bad things were wouldn’t have been too bad either. In both cases, we see how the stock didn’t reflect the headlines, but anticipated them.

Other financial planners, especially the prudent ones who espouse investing for the long haul, say that you should sell a stock once it becomes overvalued, usually meaning it has a higher-than-average price/earnings ratio. Baloney! How much money has been left on the table by people who sold a stock because it seemed “too high”? When XYZ is moving higher, it’s usually doing so for a reason. And when a trade is moving your way, don’t be in such a hurry to stand in its path. In fact, you might even think about helping it along.

What matters most, more than earnings, new products or comments from the latest talking head, is the company’s stock price. That’s what we trade and that’s what you should watch. From my perspective, a position moving against you, even on light volume or no news, is cause for concern.

But stocks fluctuate all the time. So, how do you know when weakness in XYZ is just a temporary phenomenon, or the start of something serious? Simply put, you don’t. Nobody does. But as we always like to point out, trading is a matter of technique, not mere prognostication.

Protecting profits is just as important as getting them in the first place. So when you’ve got a winner on your hands…don’t screw it up. Using a series of stop-loss orders is the best way of keeping the gains you worked so hard to score in the first place. And as much as we’d like to believe in the fallacy of “buy low, sell high,” stocks should be bought on the way up and sold on the way down, not the other way around.

The time to consider getting out of a winning stock is when a position problem begins to become a portfolio problem. That is, when weakness in an individual holding begins to affect your overall portfolio’s value. Doesn’t matter how bullish the pundits are or how cheap the stock might seem at the time, when declines in an individual holding start showing up on your bottom line, it’s time to think about scaling back. The best way to exit a stock is to do it gradually, using a series of stop-loss orders to take the emotion out the decision-making process.

A stop loss is simply an order to sell a set number of shares if the price falls to a specified level. It’s a tool for limiting your downside, and, as simple as it may sound, if you worry about protecting against losses, the gains will take care of themselves.

So if I’m long 1,000 shares of XYZ at $50, I’ll place a series of stop-loss orders under the market. That way, if the stock drops, so does my overall exposure to that particular holding. Staying clear of prices that end in 0 or 5 (everybody tends to choose them, so you will often see prices gravitate toward those numbers, only to immediately reverse direction), I might place the first stop order at $46.41, the second at $41.61. Sell 300 at your first stop, another 300 at the second. If the stock keeps falling, you should keep selling. A final exit order should be placed a couple of points above your initial purchase price, ensuring that the worst-case scenario isn’t too bad after all.

Why not just sell the entire block and be done with it? Even though I believe you shouldn’t fight the trend, it’s also true that just because a stock has moved lower doesn’t mean it will stay lower. Most people turn trading into an all-or-nothing proposition. They’ve either got their entire life’s savings in the Technology Select SPDR fund (XLK), or they wouldn’t touch tech with a 10-foot pole. So when exiting a position, don’t think in black or white, but shades of gray.

Selling off a portion at a time ensures that while you might get shaken off a stock, you won’t get shut out from its upside altogether. And if XYZ hits one of your stops, only to turn around and race higher, all the better. You’re still long, albeit with a slightly reduced position.

The advantage to using well-placed stop-loss orders is twofold: First, it saves you from having to sit in front of a screen all day long and watch the market. If your stop price is reached, your broker will execute the trade on your behalf. Very handy for folks who work in real jobs, or who aren’t plugged into real-time quotes. Second, it instills discipline into your trading plan, ensuring that you actually sell when you promised yourself you would. “Mental stops” (that’s when you just swear to yourself that you’ll sell) will do about as much for your portfolio as mental bench presses will do for your pectorals.

As your holdings rise, so should the prices of your stop-loss orders. So if XYZ jumps 10 points, your stop-loss orders should jump right along with it. This simple technique, called a “trailing stop,” is one of the best ways to ensure that you actually take home what you take in.

And what to do with the proceeds of a winning trade? A generous portion of capital gains should immediately be allocated to cash, ensuring that when the tax man comes knocking, you are able to answer the door. The remainder should sit on the sidelines awaiting reinvestment, or stuffed into savings as a permanent reminder of your job well done.

– Originally on Aug 23, 2001 by Jonathan Hoenig