Is it better to cut your losses and let your winning investments run, or to be rigorous about taking profits off the table after a stock has soared? This is a perennial debate among investors and one that's very difficult to answer one way or another. "You can't go broke taking a profit" sounds an entirely reasonable position. But so is Warren Buffett's suggestion that investors, like gardeners, should "cut out your weeds and water your flowers".
As is often the case in investment, finding the best approach is more about being consistent and sensible than the exact strategy you follow. First, ensure that you have a clear investment philosophy that you can set out in simple terms, whatever the details may be. After all, "how can you put your money at risk in the capital markets if you do not have a philosophy you can articulate"? asks US commentator and asset manager Barry Ritholtz. Spell out your possible reasons for ditching a stock before you even buy it such as a profit warning, a change of control, or a drop in earnings. Doing this should take much of the emotion and guessing out of future investment decisions.
Setting predetermined price targets and taking profits off the table can play a part in this. It enforces an investor's discipline, preventing a portfolio from becoming too heavily skewed towards a handful of standout performers. Taking profits in a stock that subsequently keeps rising can seem painful and sometimes investors are reluctant to sell for fear of regretting it later. Focusing on the gains you've made rather than the unrealised gains you didn't can be helpful (take Carl Icahn's investment in Netflix, for example see below).
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Meanwhile, using stop-losses so that you automatically exit positions that fall significantly can help you avoid the catastrophic company failures that really thump a portfolio. For most types of investor, this is likely to be even more important than looking for stratospheric gains. Much like taking profit off the table, cutting losses on stocks that fall can therefore be seen as a cautious and sensible measure.
There is a strong psychological benefit to setting stop-losses. The emotional roller-coaster that comes with active investing means that shareholders are inclined to fixate on holdings that are carrying losses, absorbing a disproportionate amount of their time. An investor's pride, as well as their original reasoning behind buying a stock, can also act as a barrier to letting go of a struggling company. Cutting losses quickly and moving on is therefore the best way to avoid a psychological sinkhole.
Whatever you do, try to avoid trading too much. There are costs to frequently tweaking positions, even though modern online stockbrokers have helped to bring trading costs down. A number of studies have found that the more actively individual investors trade, the worse their performance tends to be. Research also suggest that the stocks investors sell tend to go on to outperform the ones they buy, and that the stocks that they sell tend to be profitable positions rather than loss-making ones on average. The implication is that investors should focus on trading as little as possible and lean towards letting winners run in most circumstances.
How Carl Icahn made $1.6bn but could have made more
Had he continued to hold all his shares throughout, Icahn would be sitting on an even larger gain. Netflix is up almost nine-fold since his initial purchase. But it's hard to conclude that he made the wrong decision. "As a hardened veteran of seven bear markets," he explained at the time of his first sale, "I have learned that when you are lucky and/or smart enough to have made a total return of 457% in only 14 months it is time to take some of the chips off the table." Certainly, anybody sitting on such a substantial short-term gain would be prudent to take enough profits to cover their cost. It's simplistic to say that the remaining position gives them a free ride on further gains (there is an opportunity cost to leaving the unrealised capital gains invested), but psychologically it can be easier to handle.
What about Icahn's eventual decision to exit altogether? While this reflects his belief that there are better opportunities elsewhere, more broadly investors should take into account the sector they are investing in when deciding whether they want to be long-term holders. With industries where market leaders grow steadily over time, history suggests that constantly taking profits may not help your long-term performance. On the other hand, high-risk, high-volatility sectors, such as information technology, biotech and junior mining, have a poor track record of adding value over time. If you're sitting on a big gain and valuations look stretched, taking profits is more likely to be a smart move. Netflix, which trades on a price/earnings ratio of almost 300, very much fits this category.
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