On Poker and Investing: Let Your Winners Run, Cut Your Losses Quickly

One of the most common money management blunders made by retail investors relates to when to take a loss vs. when to take a profit. My opinion for the long term investor is that you should cut your losses quickly but be far more reluctant to sell your winners. When personal financial matters intervene, such as a child going to college or meeting retirement goals, you may have no choice but to sell. But ideally, you only want to sell when something about the stock has fundamentally changed. In First Solar’s (FSLR) case it could be a CIGS startup such as Nanosolar commercializing a product at much lower cost or a dramatic decline in the price of polysilicon. I don’t expect either of these to occur in the near future.

When I was playing high stakes poker I met a winning player who told me he was such a great player he has never left a table "stuck," or losing. At first I thought he was full of it and probably not a winning player at all. After a few hours of watching him play I realized he was indeed a good player. I began talking to him. It turns out his longest sessions was 40 hours of poker without sleep in order to eke out the tiniest of gains. I thought to myself, "wouldn't he have won more if he had gone home and gotten some sleep." He seemed more concerned with his ego and having a “1.000 batting average” than actually winning money. Just as in poker, in investing it’s not how often you win but how much. It seems obvious enough but some people go their entire life without realizing this.

I took losses in short sessions of poker regularly, but never left when winning big. The main reason is that when you're winning big there are likely good reasons both in investing and poker. In the case of poker there are probably "fish" at the table, players just throwing their money away. If you're losing, there are probably tough players in the game or you're not playing your best. In the case of stocks, there’s a good chance that your stocks that are underwater really aren't as great as you thought they were.

I once played 10-20 No Limit Hold’Em at Commerce Casino with “the Unibomber” Phil Laak. He’s known as an eccentric character. He would proudly display a graph of his winnings broken down on different time horizons and then perform technical analysis on them as if they were stock charts. At first I thought it was for mere entertainment value. But then again, he did have a Ph.D in Physics and earned a whole lot more than I did at the poker table. Maybe there was a method to his madness. I concluded that his charts were mainly used to tell him when to quit. If his bankroll remained flat or shrank over a period of several hours, it was time to go home. As applied to stocks, William J Oneil the founder of Investor's Business Daily, recommends that you liquidate a losing position after 3 months and never hold a losing position longer than 6 months in order to "keep the weeds out of your flower garden."

This is quickly becoming my favorite analogy to explain to family, friends, and other novices why valuation ratios don't work with companies in hypergrowth. Valuation ratios work on mature companies just as you could value an individuals potential lifetime earnings after they've demonstrated several years of earnings history. However, while Tiger Woods was at Stanford he had no earnings. Even if he did they would be negligible. Assume Tiger Woods did have some earnings working in the school cafeteria. His future lifetime earnings potential has absolutely nothing to do with those miniscule earnings.

Value investors may argue that when a stock doubles every three months as First Solar has, it automatically becomes overvalued and is overbought. This is a naïve view of the markets. Stocks rarely appreciate without good reason. Although this investing philosophy may help alleviate risk, statistics show that it will also water down your returns. Sure Warren Buffet has outperformed the market over many decades, but it would take him roughly 15 years to match my portfolio's YTD return.

Disclosure: Author is long FSLR.

Comments

[bgbn]

I'd like to know what else you have besides FSLR and your weighting, as you're saying that your portfolio has returned over 1000% this year. And before you continue to slag on Buffett, you do know his record right? It involves more than one stock in one year.

[bflochp]

I would suggest you refine the analogy with poker (not winning big) to leaving the table, etc. and the correllation of owning a position in anything and what you do next. I think I get the idea but you are sketchy enough without the buffett chest pounding. I'll look back on your other prognostications later as you probably have good prespective,

[Andrew Ling]

my portfolio has returned 600% this year not 1000%. Currently it's weighted 80% FSLR and 20% STP. Throughout the year I also had large gains from LVS and FXI as well as break even positions in ZOLT CCJ and SPWR. My point was that Buffet knowingly gives up opportunities for spectacular performance in favor of more consistent returns. Internet stocks are a good example. He avoids them like the plague even though most of the best performing stocks of the 90s were internet related.

If you're satisfied with 15% annual returns, go buy some houses in Texas with 20% down for $100K and rent them out. It's a much safer investment with better than 15% returns (3% leveraged) and better tax benefits.

[Jerlad]

You said: "Stocks rarely appreciate without good reason."
Absolutely not true !! It happens all the time. Thinking otherwise has gotten me into much trouble. However, I wish you luck and I enjoy your perspective.

[ken man]

You have the confidence of someone who is young and has not gone through a cycle. You concentration will probably mean that you blow up at some point - you are quite subject to the Black Swan Effect - a book you should probably read before you end up losing all your money (and then some)

[Jerlad]

I hope that you sold all you FSLR before it tanked. You would really impress me if you had sold above 250 !! Inquiring minds would like to know.

[ken man]

hows your strategy working for you now?

[Andrew Ling]

I was forced to sell a few thousand shares on the way down due to margin calls but at $300 I hit the same equity that I had previously at $280. By the way I did go through the .com cycle and my mistake there was picking stocks without "durable competitive advantage" as Warren Buffet said. The stocks that had it, like Ebay, came out fine.