Three critical timeframes for running winners and cutting losers

Monday, Dec 17 2012 by
Three critical timeframes for running winners and cutting losers

Value investors may baulk 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 summarised 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…

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Edward Croft 19th Dec '12 1 of 1

In the context of this article, I've been asked via email how momentum is generally measured - so I thought I'd answer here.

In the academic literature - momentum is generally measured by the absolute (or relative) share price return. The 'winner' portfolio is taken to be the top decile of performers in the timeframe, while losers are the bottom decile. Sometimes practitioners preferably use quintiles to study, sometimes the top/bottom 30% of stocks.

Many have tried to improve on using simple share price returns with a variety of techniques. Some have found success using 52 week highs/lows, others using long term RSI, others using the distance between the 50 day and 200 day moving averages. There are lots of ways to skin this rabbit it seems… but generally the most likely momentum outperformers are a small subset of the total market that has been most strongly rising.

See some of these articles for further reading:

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About Edward Croft

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