The elements of good trading are: (1) cutting losses, (2) cutting losses, and (3) cutting losses. If you can follow these three rules, you may have a chance. – Ed Sekoyta
Some form of this quote about controlling risk by cutting losses short is at this point a cliche in the trading literature and blogosphere. To maintain any sort of investment success traders need to recognize as well as the fact that you cannot sell winners at the first sign of a profit. Tim Richards at The Psy-Fi Blog writes:
“You never go broke taking a profit” is a horrible, thoughtless, dumb investing aphorism that deserves to be consigned to the Satanic fires along with tipsheets and day trading. It’s true, of course, but it justifies a whole raft of otherwise indefensible, idiotic and perverse trading behavior. Worse still, it panders to one of our most fundamental behavioral weaknesses, loss aversion. We just hate selling at a loss, so we will grimly hang on to loss making stocks.
Let’s grant these as trading facts. The question is what to do when you have a gain on a stock that is so big, whether it be through luck or most likely employment, that it has overtaken your portfolio? The challenge is not just a financial question but more likely an emotional one. Jason Zweig in a recent article at WSJ wrote:
If you have a small stake in a company, you own the stock. But if that stake suddenly grows enormous, the stock owns you. Thinking rationally about it then can become all but impossible—even if you have a doctorate in economics.
No matter how closely you analyzed a stock when you bought it, if it has since gone way up, then it is time to start analyzing yourself, says Meir Statman, a professor of behavioral finance at Santa Clara University.
“What many people are afraid of when they have a stock with a big gain,” he says, “is regret.” So you need to figure out which will bother you more: selling the stock and then watching it go up even more, or not selling and then watching it go down.
To manage both kinds of regret on a highflying stock, consider selling, say, 20% in five equal installments at regular intervals. That reduces the risk of selling too soon and of holding too long.
As Terrance Odean, a behavioral-finance professor at the University of California, Berkeley, puts it: “Investors should diversify emotionally as well as financially.”
Statman is right that weighing the relative risks of regret is an important aspect of managing oversized positions. So committing beforehand to a strategy of selling off stock is a reasonable one. It is not unlike the 10b5-1 plans corporate executives enter into sell stock on a periodic basis.
This question of how to deal with outsized gains is often acute for employees in companies that have recently gone public. With newly liquid (and salable) stock they have some difficult decisions to make. There are no easy answers however. Dan Egan at Betterment makes that case that holding company stock in newly public companies is dangerous because IPOs historically have underperformed the broader market.
Jon Stein at Betterment goes on to demonstrate why taxes shouldn’t play a defining role in your decision to diversify away from a single stock. In that light he talks about how having a mechanical plan in place makes sense for investors. Stein writes:
Another point where too many people get hamstrung is waiting for exactly the right moment to sell, ostensibly when the price is at the highest. This is market timing—potentially even riskier than trying to time the market as a whole. Of course, only you know your own specific situation. But generally, prudent finance means developing a plan to eliminate, or at least dramatically reduce, your single stock position in around a year (e.g., selling up to 10% per month over 10 months). The risk is, of course, that your pricing might be suboptimal in hindsight. Nobody can predict the future, but as this analysis shows, you are more likely to be pleased with your decision than to regret it.
The desire for optimal financial decision plagues too many of us. That is why investors are in a constant state of regret. With outsized positions the problem can become acute. For those willing to forgo the potential gains from hanging on to an outsized position for the long haul there are some important things you can do to deal with your position. Taxes obviously play a big role, but committing to a plan, even a suboptimal one, can help reduce regret and allow the investor to move on emotionally.
Taking some money off the table provides investors with some emotional breathing room, or as Terence Odean notes it allows investors to “diversify emotionally.” If you have been lucky enough to have a big gain consider yourself lucky (and a little bit smart) and look to the future. Do you want to be beholden to a single stock ticker and all that comes with it or do you want to give yourself a much-deserved payday and a more balanced financial life?*
*PS Everyone has to answer this question for themselves…