Managing positions: When to cut and run, when to take profits

If you are going to manage or trade a portfolio of stocks yourself, some of these techniques that we use to manage positions may be helpful to you. Once you have built a manageable, well-rounded, diversified portfolio, the hard part begins. You should try managing your positions diligently and without emotion or at least as little as humanly possible. A big factor in increasing the returns of your stock portfolio and preserving your capital may be going against your natural instincts by cutting your losses fast and letting your winners ride.

Most of us have trouble admitting we were wrong and tend to buy more of a stock that has fallen, under the guise that it's cheaper and obviously a better value than when we bought higher a short time before, instead of admitting we were wrong, cutting bait and moving on to our next idea. In fact, this can be one of the fastest ways to lose money in the stock market.

On the flip side we emotional humans are inclined to take any quick profits and sell any stock that delivers a gain right away. The more prudent course of action one may want to consider is to sell losers quickly and hang on to winners as long as they keep winning.

A lesson in market psychology

Figure 1 depicts our own modernized take of this age-old invaluable lesson in controlling your emotions when trading or making investment decisions. These comments are typical of those made during a market decline and rise. If you have ever said any of them, you are emotionally normal (in stocks, at least). But now you can be on guard should you ever utter them again. This reminder can serve to put you on notice that you have lost your self-control, and must reassert it.

Portfolio management

In my opinion, most portfolios should consist of less than 40 open positions at any time; for most individuals a stock portfolio of less than 20 is sufficient and 5-10 holdings is likely as much as one individual can effectively manage. Consider employing and utilizing some of these portfolio management techniques. In my opinion, no one position should maintain such a large percentage that it determines the future of the portfolio. Consider investing across multiple sectors and generally no one sector should compose too much of the overall portfolio. When the investor's economic and market outlook is strongly bearish (or turns negative), a more defensive posture could be instituted by limiting new buys, selling losers faster, tightening up stops and/or implementing some downside protection.

Finding proper entry points, trading around core positions, and having a sell discipline can be crucial to increasing the returns of the portfolio. Remaining disciplined, unemotional, and mitigating risk are some of the keys to investment success. Maintaining an unbiased and unemotional stock selection process and consistent portfolio management practices can help with achieving success. Most importantly, the ability to avoid bad behavior can be the difference between success and failure in the long run. Any one of the 7 deadly investing sins in Figure 2 can be the ruin of an investment portfolio.

Figure 2: Bad behavior - The 7 deadly sins to avoid

1. Averaging down into losing positions
2. Over-concentration in too few positions
3. Investing in illiquid positions
4. Falling in love with a stock, position, or a management team
5. Excessive use of margin
6. Over-concentration in one sector
7. Hubris

Finding entry points

Through the use of charts I believe you can initiate and trade positions at more timely entry and exit points. Entering even your best ideas when they are clearly overbought can be painful and expensive. Using a combination of technical tools and charts (including point & figure charts), can both increase returns and limit the number of times you get stopped out of good potential winners.

Trading around core positions

In my opinion, even "buy and monitor" can be improved by using a tier system. When your top stock positions are oversold you want to be in a full position, when they are extended in the short term you can reduce your holdings to a two-thirds or even one-third position.

Sell discipline

You may want to consider only investing in your top 5, 10, 20, 30 or 40 ideas, whatever your comfort level is. This can also be the basis of your sell discipline. When a portfolio holding no longer ranks among your top ideas it's usually for one of two reasons:

1. The company's results or the price an volume action in the stock show that a company's growth, valuation, and/or momentum has become less favorable, or
2. The stock price goes up so much that the relative attractiveness of the stock diminishes.

Either occurrence may force you to trim losses, take profits and/or find better opportunities. When factors become less favorable a natural selection process may lead you to sell a position long before a stop loss is reached and redeploy capital in another more attractive opportunity. However, a rapid increase in a stock price does not necessarily suggest a stock should be sold. Sometimes a major move gets underway and you might want to exploit those opportunities. Just a few of these per year can often have a significant impact on the performance of your entire portfolio. Selling too soon can be almost as detrimental to long-term returns as money-losing trades. This is why it can be important to harvest gains and then set trailing stop losses.

Locking-in profits

In my opinion, one of the simplest, oldest methods, and most effective ways to help lock in profits and let your winners ride, especially with lower-priced, smaller-cap stocks, is to sell half on a double. This way you take your initial investment off the table and you let your winnings ride. Or you can use a slightly more conservative approach. In order to keep it simple and since it is different for everyone commissions, fees and taxes are not considered in the following example. When a stock goes up by 40%, sell 20% of the position. When it goes up another 40%, sell another 20%. This basically leaves you with 125% of the initial position and about 60% of your initial investment off the table. You can also use this "up 40%, sell 20%" method on the remainder of the position you sold half of on a double. I think it is also prudent to use one or more outside services to rate your stocks. When those services show red flags you may want to consider tightening up stop losses for those holdings and becoming even more diligent monitoring them.

Stop losses

I do not want to get whipsawed out of a position because of small and expected pullbacks that can occur in the stock market from time to time. However, limiting large losses can be key to overall long term performance. Here are two levels of stop losses I find effective.

1. The 2% Rule. Not allowing a position to lose more than 2% of the overall portfolio. This can be prevented by proper position size and not engaging in any bad behavior as mentioned above.
2. Use no more than a 20% stop loss on each position. Many think using a liberal stop loss as high as 20% is too much. I do not. Stocks fluctuate. A 20% stop loss may not be triggered. This helps prevent getting whipsawed. If you are diligently managing your portfolio positions you could eliminate weaker performing positions long before the 20% level is hit.

JEFFREY A. HIRSCH is editor-in-chief of the Stock Trader's Almanac and Almanac Investor newsletter, and the author of The Little Book of Stock Market Cycles (Wiley, 2012).