Running winners, cutting losers

elephant.kandinsky

The Elephant

Is there everything wrong with this statement? If you want to create wealth you need to let your winners run and you have to cut your losers short. Unfortunately this statement is also an “elephant” modern finance is trying to comprehend. A few questions that can challenge this adage; what qualifies as a winner or loser? How long should one hold the winner, a few days, a few years? What happens if instead of cutting losers, we were selecting and accumulating losers? Are today’s winners tomorrow’s losers or vice versa? Is buying winners about running after growth? And selling losers about risk management or spurning value? Should all maxims be intuitive?

Inverting the elephant

We know how it sounds if we would have inverted the adage and said “running losers, cutting winners”. This would become another school of thought which would suggest, “buy in weakness and sell in strength”. So you understand our thesis now, the financial community is actually left figuring out what to do, buy or sell the winner. One may say, this is how markets work, one man’s loser is another man’s potential winner. Well the debate is more than academic and not just a matter of speculative dismissal.

Academic Conflict

DeBondt and Thaler [1985] using overreaction showcased that a stock experiencing a poor performance over a 3-5 year of period subsequently tend to outperform. This implies that, on average, stocks which are ‘losers’ in terms of returns subsequently become ‘winners’ and vice versa. This confirms that running losers and cutting winners could deliver over a 36 month period. In an SSRN paper on relative strength and portfolio management, John Lewis explains how working with relative momentum (buying strong above average performers) strategy is good for a three - to six-month period but not good for one month and larger periods above nine months. For longer periods buying above average performers (outperformers) fails.

comparatives

To read the complete article visit Business Standard or subscribe to the Time Triads Newsletter

Mukul Pal, is a Chartered Market Technician, MBA Finance and a member of the reputed Market Technicians Association (MTA). He has more than a decade of Capital Market experience dealing with derivatives and global assets. He has worked for Bombay Stock  Exchange, multinational Banks and brokerage houses in leading research positions before starting on his own in 2005. He is the President of the MTA Central and Eastern European Chapter.


Post a comment