Cutting losses

Is the first loss the smallest? How important is it to learn to take losses quickly and cleanly? In a great book “Hedge Hogging”, the author, Barton Biggs, writes about the importance of cutting losses.

“Greg is very tough about cold-bloodedly reviewing his losses. Like many traders, he does it automatically, usually at the 10% loss level. Roy Neuberger, Gerald Loeb, Bernard Baruch, and Jesse Livermore all did it. Baruch had an ego that would have fit comfortably into the Temple of Dendur, but he was an astute investor. In his book My Own Story he tells how he learned the hard way to cut his losses by selling when a po­sition went against him. He wrote:

In the stock market the first loss is usually the smallest. One of the worst mistakes anyone can make is to hold on blindly and rifuse to ad­mit that his judgment has been wrong. Occasionally one is too close to a stock. In such cases the more one knows about a subject, the more likely one is to believe he can outwit the workings of supply and demand. Experts will step in where even fools fear to tread.

Baruch argues one should always buy on a scales-up.

Many a novice will sell something he has a profit in to protect some­thing in which he has a loss. Since the good position has usually gone down the least, or may even show a profit, it is psychologically easy to let it go. With a bad stock the loss is likely to be heavy, and the impulse is to hold on to it in order to recover what has been lost. Actually the procedure one should follow is to sell the bad position and keep the good position.

Baruch wrote that one of his most important rules of investing was to "learn how to take your losses quickly and cleanly."

In Reminiscences of a Stock Operator by Edwin Lefevre, Jesse Liver­more says over and over again that you should buy on a scale-up and sell on a scale-down. "Never make a second transaction in a stock," he writes, "unless the first shows you a profit. Always sell what shows you a loss. Only suckers buy on declines."

Livermore did not have a hard-and-fast rule on when to eliminate a losing position, arguing instead that the timing depends on the feel of the stock and the market. However, he was an unusually gifted, intuitive trader, and he was not burdened by much knowledge of the fundamentals of the positions he took. Thus Livermore was more flexible in his think­ing than most of us who probably overintellectualize our stocks, and he was a dedicated believer in owning strong stocks that were in clearly de­fined, long-term up-trends. As soon as a stock he was long faltered, he got rid of it. His rule was that when a stock that had been strong failed to rally after a reaction, that was the first sign of trouble and time to get out.

Of course, buying strength and selling weakness is pure momentum investing, and as a value investor and believer in the inherent efficacy of fundamental analysis, I disdain that style. So does Warren Buffett. He has said that he doesn't believe in stop-loss disciplines. Nevertheless, you have to be respectful of the knowledge of the market. If a position goes against you by 10%, maybe somebody has understood something you have missed. When a position declines by 10%, we force ourselves to do an extensive and systematic review of the fundamentals with both inter­nal and external resources. We have to be sure nothing has changed. After the review, if nothing has changed except the price of the stock, we have to buy more. If we lack that conviction, we have to sell at least half of the position.

A trend is a trend is a trend
But the question is, will it bend?
Will it alter its course
Through some unforeseen force
And come to a premature end. . . ?

-Sir Alec Cairncross, Chief Economic Adviser

to the British Government in the 1960s”"