The Single-Most Important Decision You’ll Make As A Stock Investor

The Single-Most Important Decision You’ll Make As A Stock Investor
Reda Farran, CFA

almost 3 years ago5 mins

Mentioned in story

Imagine you’ve bought a stock, and it’s suddenly either soared or collapsed. The choice you make next arguably has a bigger impact on your investment performance than the stock you chose in the first place…

📉 Your stock’s collapsed. What should(n’t) you do?

Lee Freeman Shor – author of an incredible book called “The Art of Execution” – analyzed thousands of trades by some of the best investment managers in the world. And he categorized investors dealing with losses into three different “tribes”: rabbits, assassins, and hunters.

🐇 Rabbits do nothing when they’re losing money. They’re more interested in being right than in making money, and when a stock goes against them, they either blame it on bad luck or believe that they’re in the right and the market’s in the wrong.

But intellectually, doing nothing can never be the right decision, because either the stock rebounds – in which case you should’ve bought more – or it continues to fall, in which case you should’ve sold. And if the stock does nothing, you’d still be better off selling and putting that money to work elsewhere. In other words, don’t be a rabbit.

🎯 Assassins are quick to swallow their pride and cut their losses after a stock’s gone against them. In Shor’s experience, that was when a stock they’d bought was down between 20-30% – before it often went on to lose even more money. Assassins also generally sold positions that were down by less than that range if they’d not begun to rebound within 6 months after starting to lose money. After all, why keep on hanging onto a losing position if you could invest that money in potential winners?

🏹 Hunters add to their position after a stock they bought goes against them. That way, they bring down the average price they pay for a stock.

Here’s the rationale: let’s say you buy a stock for reasons X, Y, and Z. That’s your investment thesis. Now let’s say a few months later, the stock’s price is down but the reasons – and your thesis – are still true. If that’s the case, it’s the same opportunity, but you now have the chance to buy in at a lower price than before.

There are two things to watch out for using this approach. First, you’ll want to limit your total cumulative loss to a set number – 3-5% of your total portfolio, say – rather than constantly keep averaging down on a stock. Second, you shouldn’t average down on particularly risky stocks, like those with very high debt burdens or those at risk of technological obsolescence.

⚔️ So should you be an assassin or a hunter?

Both. The best framework is this: if a stock you’d bought is down around 25% because your investment thesis is slipping away, you should be an assassin and cut your losses. But if your investment thesis still holds, you should add to your position like a hunter.

That’s why you might want to reconsider ever investing your full intended amount into a new stock, instead investing around 80% of it. That way, if the stock goes up by 25%, it’ll take the position to your intended size. But if the stock goes down 25% and your investment thesis still holds true, you have the opportunity to increase your position to the intended amount but at a lower price.

📈 Your stock is soaring. What should(n’t) you do?

When it comes to gains, Shor categorized two “tribes”: raiders and connoisseurs.

🏃‍♂️ Raiders are quick to sell their winners and pocket their gains. But that could mean missing out on a lot more potential upside – which is exactly what happened in Shor’s findings.

And it makes sense when you think about it: the richest people in the world have never taken that strategy. You didn’t see Bill Gates and Jeff Bezos rushing to sell their entire holdings in Microsoft and Amazon respectively after they made a nice gain. They took the connoisseur strategy, and eventually became billionaires.

🍷 Connoisseurs ride their winners, but realize some of their gains by selling small amounts along the way. In Shor’s example, connoisseurs would take some profit by selling 10-20% of their total position every time it rises by 30-40%.

Cashing in intermittently gives you the benefit of your smart investment without sacrificing your long-term wealth aspirations. As for when you should finally exit the position, that’s more of an art than a science. But there are two signs it might be a good time to bow out: when your investment thesis breaks down, and/or when your stock falls from its peak by a predetermined percentage. 30-35% is usually a good guideline.

So there you have it: aim high by bringing out your inner hunter, make a killing by bringing out your inner assassin, and live a life of luxury as a connoisseur. Just whatever you do, don’t be a rabbit or a raider…

Key takeaways

  • Investment performance is largely dictated by what an investor does after they buy a stock – specifically by how they deal with both losing and winning positions over time.
  • If a stock you’ve bought tanks, revisit your investment thesis. If your thesis still holds, then add to your position. If not, sell it all.
  • If a stock you’ve bought soars, don’t be tempted to exit too early. Instead, sell a small amount of your position to realize some gains, and continue to ride out your winners.
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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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