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Value investors may balk at the idea, but William O'Neil, Wall St veteran and founder of Investors Business Daily, once compared running an investment portfolio to managing a fashion store - the best practice is to quickly discount the lines that aren't selling in order to rotate your capital into the lines that are. But while running winners and selling losers is a great maxim, for some reason it's much harder to apply in practice.

It's a primal human instinct to take profits on winners while clinging onto losers in hope they'll return to the levels we bought them at. These attitudes can be terribly costly to portfolio profits. Learning to cut losers and run winners requires fighting these human instincts, and the best weapon in the battle is to have an understanding of what I like to call the 'structure of price momentum'. Market veterans like O'Neil learn these truths from experience, but even novice investors can learn much from the following potted summary of three decades of academic research into the subject.

The structure of price momentum

Momentum has been massively researched by academics over the years and the findings can be summarized very simply as follows: In the...

  • Short term (1w to 2m) prices tend to reverse their previous trend.
  • Medium term (6m to 1y) prices tend to continue their previous trend.
  • Long term (3y to 5y) prices tend to reverse their previous trend.

These are very useful rules of thumb for those looking to time their entries and exits into stocks. In order to investigate these timeframes, continuing the fashion metaphor seems to serve us well.

The shock of the new - short term price reversals

Psychologically, people often have a strong reaction against the very new. Whether this reaction is driven by preservation or conservatism is hard to know but it's statistically a reality. Company share prices often spike up or down sharply on good or bad news but the market, in its conservatism, often acts quickly against the new information leading to temporary reversals.

It's become a well-worn hedge fund strategy now but a study by Lehmann (1990) showed that buying the market's biggest 1 week losers, and selling the biggest 1 week winners generates a profit 90% of the time! Jegadeesh (1990) also confirmed that recent returns exhibit reversals at timeframes up until 2 months.

Key Takeways - If a stock you are watching spikes up on good news, short term reversals can often provide a better entry point for purchase. - If bad news hits a stock in your portfolio and it plummets, patience often brings a better sell point within just few weeks.

Fashion lasts for a season - six month to 1 year continuations

The one momentum effect that seemingly everybody knows about is that the best six month to 12 month winners have a tendency to keep on winning for another six to 12 months afterwards. It's as if they gradually come into fashion and stay in fashion for the whole season. This also seems to work in reverse - the worst losers keep on losing.

This medium term momentum appears to be caused by the market's initial under-reaction to new information followed by an overreaction in the longer term as investors jump on the bandwagon. Whatever the cause, Jegadeesh and Titman (1993) have illustrated how strong this medium term momentum is - with the top winners outperforming the worst losers by more than 1% per month. The same statistic has been confirmed in countless other studies since such as Tortoriello's mammoth tome 'Quantitative Strategies for Achieving Alpha' which indicated that the top 6 month winners by relative strength held for a year outperform the market 3.6%.

Of course, isn't last year's fashion this year's discount line? Indeed - Jegadeesh and Titman (2001) showed that these momentum profits tend to dissipate after a year. So hanging on indefinitely is never a good idea.

Key Takeaway - If stocks in your portfolio have been top performers over the last 6m to 1 year, try to avoid selling them too hastily, instead focus on pruning the 6m to 1 year losers instead, and hold or add to your winners. - Momentum stocks added a year ago may not perform the same way the next year unless they remain in the top set of performers.

Everything comes back into fashion eventually - 3 to 5 year reversals

My wife likes to tell me that everything predictably comes back into fashion every few years, and it is equally true in the markets. A seminal study by DeBondt and Thaler (1985) illustrated that the worst three to five year price losers have a tendency to bounce back, while stocks that have been the top winners for three to five years are at a high risk of reversal. There is a concept in maths known as 'mean reversion' - that everything is magnetically drawn back to the average eventually and it's more true in the stock market than anywhere else.

A chain of positive or negative results at a company leads to an expectation that the same results will continue. The market falls in love with it's 'darlings' while shunning the rejects. But corporate success breeds complacency and grows fierce competition, while failure breeds management resolve, determination and grit! As a result, high flyers often fall to earth while outcasts can rise like the phoenix (as investors in Dart Group and Trinity Mirror can recently attest)!

One perhaps might struggle to see these as 'momentum' effects', and indeed many see these reversals as a category of value investing, but the fact that they can be analysed using price histories alone leads us to catalogue them here.

Key Takeaway - If you have been lucky enough to own some long term winners, don't get too excited by them. After three to five years of success it's worth pruning down position sizes before mean-reversion takes hold. Look to rotate into future value stock winners that often can be found on the three year lows list.

Run winners, cut losers… like an actuary!

Most people treat the stock market as though it's the fashion parade as mentioned in the opening paragraph - buying glamour stocks and shunning value. But many of the wealthiest investors have treated the market actuarially. An actuary can fairly accurately predict an average life expectancy from statistics, and in just the same way, actuarially minded investors have a greater understanding of how and when prices tend to react.

Source: 3 Critical Timeframes For Running Winners And Cutting Losers