The Psychology of the TopChop – Part 1 of 3

It has been on my mind for yonks that I need to write more on the Psychological Aspects of Investing / Trading and I regularly get asked for material along these lines via Twitter etc. The catch is that I have found it difficult to really get started on the subject although I am not totally sure why that is. Partly I feel that I know a fair bit about the subject but perhaps not in enough depth to write about it really well – and this could be holding me back from getting the enthusiasm needed to put fingers to keyboard.

Fortunately I might have found a way through the logjam (oh no, is this a form of Writer’s block?) and recent discussions on Twitter about Position Sizing and TopChops (Topslicing, Trimming, Cutting, that sort of thing) have inspired me to write some stuff about Psychology with a very clear practical basis around these Portfolio Management techniques. As you may have gleaned by now, I dislike detached, academic, theoretical writing regarding Investment and I prefer things to have a more practical and ‘Real’ underpinning – I am sure it makes it easier for me to write and far easier for Readers to understand and to put into context with their own Investing activities.

With this particular Practical Subject area I hope it will help Readers to understand and think about how our Psychological Biases and Predispositions can affect our Judgement and lead us to take certain specific types of actions with regard to how we Manage our Portfolios – many of which might not really be the best thing for us to do.

Before we get on to the Psychology stuff (in fact most of this comes from Part 2 of this Blog Series onwards), I need to set the scene with regard to the practicalities involved in TopChopping or not – the remainder of this Part covers these in detail.

The Practical Considerations
The discussions on Twitter have centred around how large individual Investors are prepared to let one Stock Position grow within their Portfolio if it does well and keeps rising nicely. If you like, this is one of the most Highest Class Problems you will ever get in Investing !!

One school of thought is that you should let the Position run as long as it wants to – with pretty much no constraints upon the relative Position Size of the Holding within the overall Portfolio. In other words, as the Percentage of the Position grows within the Portfolio, it is allowed to just keep rising and there is no Maximum %. This truly is the essence of “Run your Winners”.

The alternative school of thought is to have a Maximum Allowable Position Size % within the Portfolio. For example, my Maximum Position Size is about 8%, although I do allow a bit of flexibility here if the Stock looks undervalued despite the Gains and if it has very Strong and enduring Momentum in the Short Term. To achieve this Maximum Position Size, obviously at some point a TopChop will be necessary. In cases where a Stock I hold starts to get pretty expensive (remember, I judge ‘Expensive’ or ‘Cheap’ with regard to Valuation Measures like P/E and PEG – it has NOTHING to do with the absolute Price Level) but still has Momentum, then I watch it very closely every night and as soon as I see a Sell Signal (perhaps a very high RSI or above the Upper Bollinger Band or a Reversal Candle etc.) then I will TopChop it the next day. I recently did this on BooHoo BOO and Trifast TRI – see my ‘Trades’ page.

There is a third way but it is probably the most inferior of the Approaches (sounds like a Tony Bliar thing and obviously it will be suboptimal !!), where you just sell all the Position once you think it has topped out. The danger here is that you are certainly not “letting your Winners Run” and I have suggested many times in the past that Momentum is one of the rare ‘Free Lunches’ that the Stockmarket gives us, and we really should take the Maximum Advantage of it if we can – selling too soon can be a very costly and irritating affair (there we are, some Psychology already where you beat yourself up something rotten because the Stock you sold keeps on going up).

I will disregard the Third of these Approaches for the purposes of this Blog as by using a TopChop method rather than selling a Whole Position, this particular ‘Error’ can be avoided very simply. Instead of Selling the Whole Lot, just introduce a Rule for yourself along the lines of “When I get the urge to Sell, just sell half” or something like that. Obviously this does not mean you should never sell the Whole Lot in one go, but at least it forces you to address the issue and not just automatically go for the “Sell All” option.

A variation on all the above Approaches is to use a Stoploss method or a Trailing Stoploss. It is very possible to use a Trailing Stoploss right from the off but the danger with such an Approach is that you get Stopped Out before you really get anywhere with the Stock – if you are a Long Term Investor, then such an Approach might not really be appropriate – to my mind it is much more of a ‘Trading’ Approach.

However, once you have decided to TopChop or Sell the Whole Position, a Tight Trailing Stoploss might be a technique that is suitable – the beauty of this is that it would make the Selling Action more automatic (removing some Psychological stresses) but of course the catch is that you need to give away perhaps 5% on the Pullback to Trigger the Stoploss (or more if you have a wider Stop) and you may get Stopped Out on a spurious Spike Down intraday. Often for me I have another Stock that I wish to switch my Money into – I don’t want to be waiting around for a Stoploss to Trigger while I forget about the Stock I really want to buy or it shoots to the Moon and I miss out on it (ok, the latter rarely happens !!)

I am deliberately not going to say anymore about Stoplosses in this Blog Series – this is because I have written stacks on the subject before and in the Final Part of these Blogs I will include Links to some previous etchings. If you are massively impatient (you need to cut that out if you want to be a Successful Investor !!) then use the New Super Dooper Whizzy Search Boxes to track the Stoploss Blogs down (there‘s one at the Top of the Homepage).

I will now look at the Advantages/Disadvantages of the first 2 techniques as I see them. Please note I have my own Psychological Bias here towards the TopChopping Approach – that is not to say I am right or that the other Approach has no validity – the aim of this Blog Series is really just to make Readers (and me !!) think about the issues and what drives us to think in the way we do about these different Approaches. As with so much in Investing / Trading, there are no Right or Wrong answers – it is very much about finding an Approach that you are comfortable with (and such ‘comfort’ is very much about your Psychological Wellbeing and Mental Balance – Stressed Investors / Traders are rarely Successful.)

Advantages / Disadvantages of No Position Size Limit
Advantages:

  • Makes full use of the Momentum Effect (never underestimate the Power of Momentum), and a true evocation of the “Run your Winners” adage. 
  • No need to think about how much to Chop off – has a certain simplicity.
  • Very much a Darwinian “Survival of the Fittest” approach to Portfolio Management – the Stocks in effect determine their own future.
  • In a Strong Bull Market where everything is rising (even Utter Junk Stocks), such an approach may outperform a Portfolio that has more innate ‘Balance’. This makes sense – High Risk can often lead to High Reward (when things go well !!), but of course has the drawback that you can get severely toasted when Markets get nasty (I suspect there are many Investors / Traders around who have never experienced the kind of Bear Markets we had in 2003 / 2008 – after such horrible times, I never take Risks that are avoidable and which would put my Portfolio in extreme Danger).

Disadvantages:

  • An Individual Stock Position can get ‘Out of Balance’ with the rest of the Portfolio which increases the overall Risk of the Portfolio and destroys the other ‘Free Lunch’ in Investment of Diversification. This is because of 2 main reasons – firstly, “Risk rises as a Stock goes up” (particularly ‘Valuation Risk’) and secondly because a well Diversified Portfolio with maybe 20 Stocks can be transformed into a Portfolio which exhibit’s the Risk Characteristics of a much Smaller Portfolio. If the Portfolio has 20 Stocks of equal size, then the Maximum Hit one Position can give you is 5%. On the other hand, let’s say one Position grows to be 20% of the Portfolio – now that Stock can give you a Maximum Hit of 20% – in other words, your 20 Stock Portfolio is behaving in a similar way to a Portfolio that only holds 5 Stocks (ok, I am stretching things a bit but the point should be obvious). You may counter that Stocks rarely fall 100% in one day (or even over several months) but the point is that Small Stocks can regularly fall 50% in one day – Quantum Pharma QP. did that to me a couple of weeks ago, and a similar thing happened to many Crawshaw CRAW holders recently. A 50% Drop in one Position would wipe out 10% from the Portfolio if the Position was 20%.
  • In some ways letting Positions grow to the Moon has an ‘All or nothing’ element to it – at some point you will have to make a Decision to Sell and you will by definition Sell the whole lot in one go. Of course the problem here is that you may sell too early and the Stock keeps going up which will really grate on your nerves (more Psychology); and the other Problem is that you sell too late and you miss out on a lot of ‘Paper Profit’ converting into ‘Banked Profit’. There is a ‘Time Factor’ here as well – all Stocks are just heading towards their Next Profit Warning – this is a sad fact of life and very little appreciated. The longer you hold a Stock the closer it is to its next Warning – and if it has run up to a very High and Stretched Valuation then it is going to kick you very hard.
  • Letting a Position grow really big can create Liquidity Problems when you try to sell – particularly with Small Cap and AIM Stocks where you simply might not be able to get your Stock away at anything near the Quoted Minimum Market Size – you might lose perhaps 5% or so simply because of this. This issue would be exacerbated if you try to sell during a wider Market Sell-off Panic. For people with truly huge Positions in Small Stocks, then often it is the case that they are forced to “Sell when the Ducks are Quacking” (I think it is Leon Boros @Boros10 who says this in the superb book ‘Free Capital’ – you can pick up a copy from Wheelie’s Bookshop). In other words, when there is a lot of excitement and bullishness in their Stock, they have to take advantage of the demand to shift some of their Position – this is a huge disadvantage for Big Players and in particular for Fund Managers. Of course this is a form of TopChopping.
  • May cause more Psychological Angst than deployment of a TopChop approach – I will cover this in further Parts of this Blog Series.

Disadvantages / Advantages of a Sneaky TopChop
Disadvantages:

  • Danger of doing TopChop too early and missing out on a lot of the Momentum Gains – as with anything, must be used with a lot of careful thought beforehand. However, at least you are ‘Still in the Game’.
  • Arguably goes against the “Run your Winners” Rule (I suspect this is the main Argument of People who prefer a ‘No Position Size Limit’ approach).
  • Incurs higher Dealing Fees and Spread Costs.
  • May under perform a ‘No Position Size Limit’ approach in a Bull Market.

Advantages:

  • Very much part of a “Scaling In, Scaling Out” approach to managing Positions. This enables taking advantage of using ‘Average Buy Price’ and ‘Average Sell Price’ to help overcome Market Timing issues. With an ‘All or Nothing’ Approach your Entry and Exit Timing needs to be extremely accurate (very few people can achieve this consistently time after time).
  • Does not dilute the Diversification Benefits across a Portfolio like the having ‘No Position Size Limits’ approach does. Results in Lower Risk overall.
  • Can free up Cash to use elsewhere in the Portfolio – for instance your Winner may be getting very fully valued and you think the Upside is reducing – you can move some Cash out of it and into another Stock you hold where you think the Upside Potential is far higher at that point in time.
  • Many Psychological Benefits which I shall come onto in the next Parts of this Blog Series.


Did you notice there how I reversed the Order of the ‘Advantages / Disadvantages’ Bullet Points for each of the Approaches? – believe it or not, this could well have affected how you Psychologically assessed the individual approaches. This is something that gets covered in Daniel Kahneman’s outstanding work “Thinking, Fast and Slow” – you can get a copy from Wheelie’s Bookshop and it is well worth the investment.

That’s it for Part 1 – sorry there is not much Psychology yet, but it is critical you understand the Techniques involved so the Psychological bits ot come are relevant.

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