Sell Your Losers

Some market truisms seem positively antique they’re so deeply woven into the fabric of the Street. For example, “Don’t fight the tape.” Of course, they haven’t used tape for years — it’s long been a digital display. But everyone knows what it means.

“Don’t fight the Fed” is a bit more modern. And with Alan Greenspan leery of our overheating as the Japanese market did a decade ago (rich at 20,000 on the Nikkei Dow it nonetheless doubled — 40,000 — before dropping back to 14,000), one might keep that one in mind. I wouldn’t be surprised to hear him one of these days float the possibility of raising margin requirements from 50% to 55% or 60%. “The economy is sound,” he might say. “Stock market values reflect that. But one does worry whether some of the ‘irrational exuberance’ I speculated on a few months ago might not at some point warrant our considering the possibility of nudging the marginal market participant toward more prudence, perhaps by a small adjustment to the margin requirements.” Of course, it would be a much longer sentence than that, nestled into the middle of an answer to the New Delhi Times on the topic of agrarian reform. Never want to be too straightforward at the Fed.

Anyway, the truism I had in mind for this morning: “Cut your losses and let your winners run.” It is not something I’m good at. On the loss side, I’m stubborn and egotistical and have lost a load of cash over the years with this unassailable logic: “If it was a good value at 10, it must be a great value at 6.” (And then 4 and then 2.)

Sometimes, though not nearly as often as I’d have liked, that line works. I bought Citibank at 27 before it fell to 10, more at 10, and now it’s a million.

But that leads me to the second half of this: let your winners run. How much Citibank do you think I still own here at a million (well, 114)? I think I sold my last shares a while back at 40.

There are a lot of reasons for this, some rational, some psychological. I was on a panel recently with a psychiatrist who ascribed this sort of behavior to a “castration complex.” OK. Whatever.

The only point I want to make is that — in a taxable account — there is more than just market lore, or even common sense, going for this old saw. Cutting your losses makes for smallish but realized capital losses that will lower your income tax. And letting your profits run lets them grow tax-deferred.

Of course, if you never sell winners, in order never to pay taxes, you run the risk of owning some very over-priced stocks — and then, eventually, some stocks that crash back down to earth. “Don’t sell IBM” was almost as widely accepted wisdom for a couple of decades, as it rose to 400 and beyond, as “don’t fight the tape.” But then it fell to 40-something before the eventual turnaround.

So like most old saws, this one doesn’t always cut it. But think about it: “Cut your losses, let your profits run.” There’s the simple logic that if “the market” is going against you, maybe the market knows something you don’t and that if a stock is doing well, it may be because management of the underlying company is smart and will continue to be smart and will do a good job of growing earnings and dividends and so forth.

But however sound the basic logic underlying this strategy, taxes give it extra weight. Cut your losses; let your profits run.

Tomorrow: How to Take a Compliment