Small Disciplined Losses

Small Disciplined Losses

Small Losses Are the Mark of a Disciplined Trader

By Dr. Winton Felt

The single most identifiable mark of a disciplined trader is that he will sell quickly stocks that lose and continue to hold stocks that gain. Accordingly his trade confirmations will show only small losses. A person cannot achieve this without discipline. A string of controlled losses is one of the by-products of active risk management. If all losses are blunted while gains are allowed to run, the net result should be portfolio gains (even if there have been more losers than gainers). This is not merely theory. I have seen and measured the effect in many different winning strategies..

Let me use a mining metaphor to illustrate the point. The experienced trader takes numerous positions. This is his “mining” operation. By taking numerous positions he is “digging and scraping,” as he searches for nuggets of “gold.” In the process, he’ll find plenty of worthless rocks and an occasional piece of “fool’s gold.” The worthless rocks and “fool’s gold” are the stocks that disappoint. These are the situations where the expected surge in price does not take place, or where the stock falls instead of rising. He will quickly toss these losers aside as the cost of doing business, and keep digging. Unless he is operating under hostile market conditions, the value of the “gold” that is found should more than offset the cost of digging through the rocks and “fool’s gold.” The assumption made here is that our trader is buying when the odds for a positive move are in his favor because he is buying near support or on promising setup configurations. Short-term traders should plan trades so that the expected gain-to-loss ratio is about three to one. Of course, the discipline works best under favorable market environments.

In tracking the progress of your account, it is important that you measure portfolio value rather than tally losses and gains on trades. Why? In a volatile market there may be many more losses than gains, and that could be discouraging (and discouragement can cause emotions to become a part of your decision-making). Your goal should be to sell losers quickly and hold winners in the account as long as they are winning. Therefore, even though there may be more losses, the total gain should surpass the total loss. If very little time is spent with losers and a lot of time is spent with gainers, the value of the portfolio will tend to increase. Let me give a little more explanation of this point.

In a convulsive or roiling market, a comparison of your trade confirmations will show more losers than winners. If you are quick to realize a loss (so it won’t become a bigger loss) but slow to realize a profit (so it can become a bigger profit), you will have a higher turnover rate for losers. Therefore, if you simply compare trade confirmations, you may become discouraged by all the losses. Instead, check portfolio values. Your portfolio should be increasing in value. The growth in portfolio value will confirm that your procedure is correct. You may be down in any given week, but the overall trend of account values should be positive. In addition, the net effect of the quick sale of deteriorating situations is risk reduction. Holding on to a loser is risking further asset loss on a bet that a stock that has already disappointed once by doing the unexpected will have a “change of heart,” reverse course, and reward us for our loyalty. This is really a form of self-deception, reflecting an inability to admit that a mistake has been made.

This strategy will also dramatically improve the effective risk profile of your portfolio. Many consider the volatility of a portfolio to be a measure of its risk. However, volatility as measured by taking the standard deviation of account values, would not be an appropriate measure of risk in this case. That’s because most of the volatility in the value of your account would be to the upside. The normal downside fluctuations in account value would be significantly blunted. Trends tend to persist. Think of Newton’s law. “A body in motion tends to remain in motion unless acted upon by some outside force.” Stock trends are similar to a body in motion. When you remove a stock from your portfolio, you become the “outside force.” The risk of further decline in that particular investment is eliminated when you convert the stock position to a cash position. This results in another benefit. The cash gives flexibility. It will enable the trader to take advantage of another opportunity for which the timing is right. That beats “holding and hoping” any day.

Here is the pattern you will see. You will have a string of small losses and a string of small gains. In addition, you will have occasional large gains but no large losses. Though stocks are sold immediately if they are misbehaving, some latitude may be permitted at times because a stock may have multiple support zones in close proximity, and it may be difficult to know which one will give the support needed to reverse a decline. Over time, this approach will cause your portfolio to have a concentration of winners, not losers. This will provide some encouragement that you are doing the right thing. The length of time you hold winners and the shortness of time you hold losers is what causes portfolio growth.

Let me illustrate. On a certain date in a real portfolio, I noticed that 8 out of 11 positions were up and the average gain was much larger than the average loss. After little more than a month our winning stocks had unrealized gains of 19%, 15%, 9%, 5%, 27%, 6%, 9%, and 10%. Our losing stocks had unrealized losses of -1%, -1%, -2%. I recorded these numbers at the time because I was using them in correspondence with a friend and advisory client. These stocks were all the stocks that were in the account at the time. Of course, the losses we had realized averaged a little more than the 1% to 2% losses that we still had in the account, because the losses in the account were not yet large enough to trigger a sale. Even so, account values had been rising, not declining. The cumulative negative impact of the controlled losses was more than offset by the cumulative positive impact of our gains. traders never ignore paper profits and losses. They are real and they reflect current portfolio worth. Comparing the longer string of relatively large profits with the shorter string of relatively small losses was encouraging and enlightening to my friend. He was concerned that the confirmation slips he received from his broker showed a string of losses and a relatively small number of gains. He had kept his eyes on the losses rather than on the value of his account. Once he saw that his account had experienced rapid growth during the same time his confirmation slips showed mostly losses, he became a believer in the strategy.