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gameguru (33.42)

Always Cut Your Losses!?

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January 25, 2007 – Comments (2)

I came across this article today:

http://biz.yahoo.com/ibd/070124/corner.html

Based on the CANSLIM method, it advocates ALWAYS cutting your losses when they reach 7-8% of the position. No exceptions.

I've known about CANSLIM for many years, and I've corresponded with people who swear by it, but it has never really appealed to me as an investment strategy. I'll leave an in-depth discussion of my reasons for another time...

For now, suffice it to say that I don't follow the CANSLIM advice regarding cutting your losses. In fact, I often do the opposite, and let my losers drop by 10-15% and then buy more. Sometimes, such a loser will drop even further, down to 20-50% from my original position. And I'll still buy more.

So, what's the deal? Am I just a sucker?

I don't think so. Let's put it in a more concrete arena. Imagine you and your favorite CANSLIMmer are at a flea market. You both are at a booth early in the day, and you find what you think is a real bargain piece of merchandise. You each buy a few. Later in the day, as you're wandering among other booths, you hear a loudspeaker announcement that the merchandise you bought earlier is now on sale - a deep discount of at least 10%. You rush back to the booth and what do you do? Your CANSLIM acolyte friend sells his to another buyer at the discounted price! Do you do the same, or do you start scooping up more of the merchandise? I know what I would do. I wish I had such a CANSLIM friend, from whom I would buy their discounted merchandise as they are in a panic to sell! After all, nothing has changed about that piece of merchandise, only the current market circumstances. Maybe the seller at the booth was getting ready to close up and doesn't want to haul unsold merchandise home. Or maybe it's toward the end of the reporting period and the seller wants to show top-line growth. Nothing about the fundamentals has changed in this situation.

In fact, several such "losers" have gone on to become some of my best performers and now make up hefty portfolio positions for me. (Examples of these include COF and AB, which, in years past, I watched fall nearly 50% from my initial purchase price, and yet I bought more. Both are now up over 100% on the total position for me.) Admittedly, these could just be isolated examples, where I happened to get lucky. But I think they were instances of recognizing "discounted merchandise". And there are many other successful investors who employ a similar mindset.

I've recently been reading "HedgeHogging" by Barton Biggs (it's both informative and entertaining, and I would recommend it highly). In it, Biggs describes a policy employed at the Traxis hedge fund, in which he is a partner. By policy, whenever a position is down 10%, it triggers an automatic review of that position. If the partners continue to like the fundamental outlook, they must purchase more. If not, they must sell it. If the position falls again, they do another review, and so on...This mindset seems to be a much better one. It does keep your attention on your losers and has you periodically reviewing them - without such attention and review, you're not going to learn from your mistakes. But it also recognizes that sometimes, losers may not be mistakes after all, and present even more attractive buying opportunities. This is something that I'll likely incorporate moreso into my own approach - buy more or get out. Because I don't have the same liquidity as a hedge fund, I'll take a modified approach - sell only if you wouldn't buy more if you had the money to do so.

In CAPS, you can't take Biggs' approach, because you currently can't "buy" more of a position. But you can certainly use the modified approach - end the pick if you wouldn't start a new pick at this price. Looking at my losing picks down 10% or more (KONG and CCRT), I would happily pick KONG again - I only wish I had waited a while to pick it so I could get the lower price, but nothing has changed in my analysis of the company. As far as I can tell, KONG is an end of the day sale at the flea market. Since my CCRT pick, the company announced lowered earnings, so my valuation drops a bit, but I still see it as being undervalued. I'm going to review the company a bit more, and then make a decision. I may even buy more in real life.

So thanks, CANSLIM, for getting me to think more deeply about my own methods, even though I think you're fundamentally wrong.

Enjoy!

2 Comments – Post Your Own

#1) On February 21, 2007 at 11:13 PM, JrnymanInvestor (79.68) wrote:

I agree that cutting your losses at an arbitrary point makes no sense at all if you know the company is a good one.

Check out the CAPS player EPSmomentum for an extreme example of the cut-your-losses kind of strategy. 100th percentile score. 0 percentile accuracy. It actually does look like his strategy can be successful for an active trader (at least in certain market conditions). I am guessing that he screens by earnings per share momentum, based on his Fool name. But score per pick is on the low side.

If you buy based on price movement or other individual indicators, cutting your losses may be sensible. If you buy based on knowing the company is on sale compared to its intrinsic value, then your flea market description is perfectly apt.

Great topic!

-Julie

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#2) On February 22, 2007 at 12:40 AM, JrnymanInvestor (79.68) wrote:

P.S. It's actually EPS100momentum, and now I think it's more likely he's just screening on stock price momentum.

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