Hot Money Monday: Hold your winners, and cut your losers – but is that really the best strategy?

Disposition Effect is when you sell winners too soon and hold losers too long
Should investors actually let profits run?
And should we be cutting losses or sticking to a.Buy-and-Hold strategy?

We’ve all fallen victim to a phenomenon called the “disposition effect”, a widely-studied behavioural finance topic that affects every investor.

This phenomenon refers to our tendency to sell winning stocks early to cash in on profits, while holding on to those that are losing money.

Whether you’re a newbie investor or a seasoned pro, logical or irrational, chances are you’ve been guilty of doing just that.

There’s been a lot of academic research done on this topic, and they all indicate that succumbing to this phenomenon ultimately results in lower long-term returns.

To look at the psychology of why disposition effect happens, let’s say someone comes up to you and asks if you want to flip a coin:

Tails = You lose $100
Heads = You win $200

Sounds like a good deal, right? But most people would pass on it, even though the odds are clearly in their favour.

Why? Well, the thought of losing a hundred bucks is enough to scare most people off.

People will go to great lengths to dodge losses, and our brains are wired to be more scared of losing than excited about winning, and that’s why we don’t like to cut our losses.

Scientists put this down to our survival instinct, ie; if we are more averse to negative events than positive, then we are more likely to avoid danger and survive.

“Behavioural finance finds that people feel the pain of loss twice as strongly as they experience an equivalent gain as pleasurable,” said a research paper from Blackrock.

Why let your profits run?

The “let your profits run” strategy is accredited to 18th-century economist, David Ricardo.

The question is: is that really good advice?

Over the years, experts have delved into this question, and many have found that letting winning stocks run is in fact a good strategy.

“Momentum investing requires a great deal of patience, but when it does work, it works phenomenally well,” said Gary Antonacci in his book, Dual Momentum Investing: An Innovative Strategy for Higher Returns with Lower Risk.

“The key is sticking to your strategy and not letting emotions interfere with your decisions,” he wrote.

Another expert known as the Father of Momentum Investing, Richard Driehaus, has asserted that instead of looking for undervalued stocks, an investor should instead focus on buying high and selling even higher.

The “Driehaus Strategy”, as it’s known in the market, involves identifying and buying stocks in a strong upward price move. The key point of the Driehaus strategy is to stay with the stocks i.e. don’t sell, in order to seek that “home run”.

Another expert, famed hedge fund manager Paul Tudor Jones, says that he believes in riding the momentum of a stock until it shows signs of reversal, saying that those stocks have a higher probability of continuing their upward trajectory in the near term.

Cut losses or buy-and-hold ?

Cutting losses, on the other hand, is one of the most important principles in stock trading, yet it is the most difficult to put into practice.

Determining the appropriate time to exit a position isn’t a straightforward matter. It depends on individual trading strategies and risk tolerance levels.

Some opt to sell after experiencing a 2% loss, while others are willing to endure setbacks of 20% before making the decision to cut.

One rule of thumb that’s been widely preached in the market is to cut losses anytime a stock falls 7-8% below the price you purchased it at.

“This basic principle helps you cap your potential downside. And it is the simplest way to make sure you never let a small loss become a big one,” said market expert, Rushit Sejpal.

That said, trying to sell blindly at pre-determined points might not be a winning strategy either.

“Instead of trying to time the market, consider spending time in the market,” said a note from U.S. Wealth Management.

“You may find that a passive investment strategy, such as buy-and-hold, can help you gain long-term returns.

“For most investors, a buy-and-hold strategy can also result in quicker loss recuperation.”

Top 20 best ASX small caps in 2024

On that note, here the top performing ASX small caps this year, measured by YTD returns:

WordPress Table Plugin

The post Hot Money Monday: Hold your winners, and cut your losers – but is that really the best strategy? appeared first on Stockhead.