"Cutting Winners Short": Of French Fries, Billionaires, and the Chinese B-shares

J. R. Simplot is an American eighth-grade dropout and a self-made multi-billionaire. He made his fortune through saavy investments in potato farming and french fry production. Currently he owns the largest ranch in the United States, the ZX Ranch in southern Oregon. His ranch is larger than the state of Delaware. Despite his tremendous wealth, Simplot is a modest man. He describes his accumulation of wealth to interviewer Eric Schlosser in the book Fast Food Nation:

"Hell, fellow, I'm just an old farmer got some luck," Simplot said, when I asked about the keys to his success. "The only thing I did smart, and just remember this—ninety-nine percent of people would have sold out when they got their first twenty-five or thirty million. I didn't sell out. I just hung on.”

Simplot's key to success was holding on to his winning investments. For most people, when their investments are doing well, they become afraid of giving back their gains. As a result, they do what Wall Streeters call "cutting winners short." Academics call this "the disposition effect."

I recently opened an account statement for one of my brokerage accounts, and I was shocked by the sudden increase in value since the beginning of this year. My first thought? "I've got to sell these stocks to be sure I keep the money." I was first elated by the large gain and then terrified of losing it. My fear inclined me towards selling out.

With world stock markets hitting all-time highs every week, there is a considerable amount of nervousness among long-term investors about the sustainability of the rallies. In China, investors who have been in the market since mid-2005 have 3-4 fold gains. Last week many Chinese B-share stocks were limit up (+10%) each day for 4 days in a row. That kind of gain is terrifying because 1) it makes no fundamental sense and 2) I might lose my enormous paper profits if the market turns down. With Goldman-Sachs analysts on CNBC calling the Chinese market an "overvalued bubble," I have more reason to fear a decline. Yet, as Simplot noted above, truly long-term investors can make an even greater fortune by riding their winners higher, not by selling out too soon.

Whether the Chinese markets will continue their rally is debatable. For psychological reasons, I think the Chinese markets will top in Spring 2008, a few months before the Beijing Olympics. What is most interesting to me now is the tremendous pressure that many long-term investors feel to take profits. Truth be told - if a downturn hits over the next few months, many probably will sell out. There's nothing like short-term declines to prompt long-term investors to "cut winners short."

This photo was taken in 2004 at a Shanghai brokerage (before a muscled bouncer showed me the door). We have had a marketpsych page devoted to Chinese stocks since 2004 here.

Richard