The traditional advice to 'cut your losers and run your winners' is not always correct, according to new research.
Very often, it is a good rule. It encourages us to profit from momentum, the tendency for past winners to continue rising and past losers to continue falling. And it tells us not to suffer from the disposition effect, our tendency to hold onto losing stocks in the hope that they'll return to the price at which we bought them.
However, Fang Tang and Jianhong Mu, two economists at the University of Texas, have found an exception to the rule. They have found that the VIX index - the so-called fear gauge - "has significant and robust power to forecast momentum payoffs". A high VIX leads to losses on momentum investing.
This is not because it leads to past winners doing badly. Instead, it is because when the VIX is high, past losers subsequently rise. Cutting losers will then lose you money.
This could be because when the VIX is high, investors are panicking, which causes sentiment towards loser stocks to turn especially bad. This more than offsets the usual tendency for investors to underreact, and so past losers become underpriced with the result that they subsequently bounce back.
Although this research is based upon US evidence, it applies to the UK recently. For example, at the end of last September, the VIX was high as investors worried about the euro crisis. This led to the third-quarter's worst-performing stocks doing very well in October. And at the end of March, the VIX was low and investors were calm, and the first-quarter's worst performers did badly in April and May.
With the VIX quite low now, the old rule to cut losers probably still applies. However, when the market next panics and the VIX rises - which is a when not an if - then we should suspend the rule.
Yes, rules can very often help investors. But sometimes, it pays to know when to break the rules.
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Chris blogs at http://stumblingandmumbling.typepad.com