Winning Stocks Make Investing a Game of Outliers

Winning stocks overwhelmingly drive your portfolio performance, so it's important to use strategies that give them room to run.


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I recently skipped on down to Florida for a week off with my wife, daughter and in-laws. The weather was great for all but one day, and about the only source of any stress was my jaw-droppingly bad tee shots during a couple rounds of golf. First rounds of the season, though, so no worries. As usual, the time out of the office allowed me to step away from the day-to-day grind of the market and look at the bigger picture, not just in terms of the market, but also in terms of my own trading, my winning stocks and losing stocks. I’ve learned many new tricks of the trade lying lazily by the pool.

Anyway, I was reviewing some past trades and the overall market when I stumbled upon a reality that I was always aware of, but never really put into words. And that is the subject of my advice today:  Investing is really a game of outliers.

The way I think about it is this: If you review your trades for any one- or two-year period and sort them from biggest loser (money-wise) to biggest winner, my guess is that you’ll find the “middle 70%” cancel each other out. In other words, the vast majority of your trades will add up to zero (or near zero), meaning that it’s the big losers and big winning stocks that determine how your portfolio performed.

Logically, then, what you want to do is let your winning stocks run and cut all losses short … which is the foundation of every solid growth stock investing system.  However, there’s a lot more you can do than simply using loss limits and trailing stops.

The first thing to realize is that the method you use to, say, cut losses short, can also affect your ability to produce winning stocks. They’re intertwined.

For example, I recently examined Peloton (PTON) which had gapped up on high volume at the end of the year, and everything was in place for higher prices, the price action (up 11% to new highs), volume (three times average) and the firm’s story. You could have bought the stock around 159 or so on the day of the gap; it closed around 161.

If you immediately set a mental stop to keep any potential loss very small, placing it just below the low of the gap day, you would have placed that stop somewhere around 155. That works out to a loss of just under 4%. Sounds good to me, the smaller the better, right?

Well, PTON pulled back a bit with the market in the days that followed and would have knocked you out. No reason to be too upset, a loss of less than 4% meant the trade did little harm to the portfolio.

But look what happened afterwards, the stock traded just a hair through the gap, found support, and is now back near all-time highs. In other words, net-net, the only thing an overly tight stop did was get you a 4% loss, instead of a healthy stock looking for new highs.

While I won’t claim that it qualifies as a “big winning stock,” my point is that if you’re extremely risk averse and cut losses too short, you can actually cost yourself quite a bit of money.

Thus, on the loss side, my advice is simple, be willing to give a stock 8% to 15%, in general, before abandoning ship.

Holding on to a couple of longer-term winning stocks is tougher than cutting losses. The real trick is to develop what we call staying power, that is, a combination of a profit cushion and the mental wherewithal to sit through the inevitable deep, quick, scary corrections that even the best stocks have.

It’s easiest to hold on to a long-term winning stock when you have just a single share of stock; the money invested is so small that you can sit through a 20% or 30% retreat without breaking a sweat. Of course, with one share, you’ll never make any real money.

Thus, the goal is to put on a position size that’s small enough so you don’t freak out when a stock suffers a sharp retreat … but large enough that your portfolio reaps some serious benefits.

My point is that you need to focus on developing at least a few large winning stocks during a bull market. Make it a point of emphasis in your own trading. If you’re the type that constantly takes profits when you’re up 10% or 15%, try to take partial profits instead (selling half your shares) while holding the other half with a trailing stop.

If you’re the type that gets nervous about losing even a 5% profit, consider buying smaller amounts initially, so that the swings of a few percent don’t impact your psyche.

And if you’re the type that is so risk-averse that you’ll never put on a large initial position, then consider building a position over a few weeks, averaging up two or three times (if the stock heads higher) so that, if the stock does get cranking, you have a good-sized position.

There’s no magic bullet, but just remember that, in the big picture, it’s the outliers that will determine the lion’s share of your performance.

As for the current market, I’m bullish.  Of course, I’m also keeping my feet on the ground, knowing that after a big rally, some sharp shakeouts or even a full-blown market decline could be in the cards. But the overall trend remains very healthy, both among the indexes and leading stocks.

My biggest piece of advice for you right now is to stay focused on the leaders of this advance. In my experience, it’s around this time where investors either (a) fall back in love with some old, past leaders whose best days are behind them, or (b) start buying up speculative or lagging stocks.

In a bull market, you might get away with buying a few dogs, but your best course of action is to stick with the primary or secondary leaders of the advance. In this environment, if you buy the right stocks at opportune entry points, your odds of success are very high.

*This post has been updated from a previously published version.

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