The power of letting winners run

Most investing missives focus on finding and backing winners. The logic makes sense. One of the better ways to enhance portfolio performance is to improve the feedstock of investments into the process. The downside is that strategy around portfolio management often gets short shrift.

A challenging aspect of portfolio management is the handling of extreme winners and losers. It tests both the process and psyche of portfolio managers but also how they manage the positions within the overall portfolio.

Dealing with extreme losers is the most common problem. A 2014 study by J.P. Morgan found that, over 25 years, 40% of all stocks in the Russell 3000 index suffered a catastrophic loss of 70% or more from their peak. Another study by Blackstar Funds found that 39% of stocks had a negative lifetime total return. Big losses happen with surprising frequency.

All those losses can make for a pair of silver linings, though.

The first is that, because losses occur so frequently, investors get plenty of experience on how to handle them and have developed clear frameworks for how to manage extreme losers.

The second is that, at least when wrong on the long side, the position size has shrunk and whether the portfolio manager decides to sell is of much less consequence.

The challenge with extreme winners

Handling winners is a more complex task, especially at the extremes. Conventional wisdom is keen on locking in profits with some form of the saying such as “You never go broke taking a profit.”

But locking in profits on winners cuts against the defining advantage of investing in equities: losses are capped while gains are not. The lean-but-long right tail of winners overcompensates for the limited losers. The same J.P. Morgan study found that only a third of stocks manage to beat the benchmark. In other words, it’s a small subset of winners that more than make up for a huge chunk of losers.

Closing out a winner purely for the sake of locking in a gain snuffs out the long tail of potential upside. For example, the BlackStar Funds study found that 6.1% of the stocks in its 24-year study of the Russell 3000 outperformed that benchmark by more than 500 percentage points.

Imagine having an approach to selling which embraces locking in a profit at a 50% gain only to find out that the sold stock then outperformed the benchmark by nine times the size of your profit. Even if the benchmark went nowhere, it would take another nine-plus 50% gains from other positions to make up for the forgone gains. A fundamental approach that embraces locking in small gains in stocks can make for the worst of both worlds: it retains the risk of loss but eliminates the long tail of potential upside that more than offsets the regular flow of losses.

Worse, the odds of an investor catching lightning in a bottle with the proceeds of selling a winner are unlikely given that the base rate says that roughly two-thirds of stocks underperform their benchmarks. The more times that process is repeated, the more likely an investor cashing in winners is to generate benchmark-trailing results.

There are two other good reasons to err on the side of not rushing to sell winners.

The first is that study after study, including the beautifully titled Trading Is Hazardous to Your Wealth, reflects that portfolio turnover is inversely correlated to performance. On average, these studies all point to the average high-turnover investor underperforming the average patient investor.

The second is for tax: longer holding periods can allow for more favourable taxation on individual gains and make for fewer tax drag pit stops on the compounding journey.

Where the rubber meets the road

And so logic would say that letting winners run is a sensible plan for the typical long-term investor. As usual, though, the answer on whether and how far to let an individual stock run begins with an “it depends”.

For starters, know that having a long-term approach is not an excuse to not stay on top of new information and how a thesis is evolving, even if that investment is working out well. Indeed, as a position swells to take up more room in the portfolio, so should it gobble up more of the portfolio manager’s mindshare.

Investors who let winners run should also brace for a more concentrated portfolio as the winners expand and the losers shrink. Greater concentration typically also makes for greater volatility, which can unsettle some investors. I personally prefer backing my best ideas with conviction as it suits my temperament and is well supported by empirical research.

There’s also the matter of valuation. Almost every runaway winner looks conventionally expensive at some point, making for a greater chance of a drawdown. That said, outside of broad-based macro factors which affect most stocks (e.g. falling interest rates), companies that get re-rated higher usually do so for a very basic reason: the fundamentals have improved and are beating expectations. As a long-term, high-conviction investor, my Darwinian bias is to let such companies grow to be a larger part of my portfolio and let those that fall short shrink.

Just how large a position size that is tolerable for an individual investor is a function of that person’s individual circumstances, including their willingness and capacity to take that risk. What suits me may not suit you. Big picture, though, long-term investors would do well to ponder what kind of returns they may be leaving on the table by ‘locking in a profit’ next time around.