The majority of commentary about trading and investing focuses on the buying decision. Finding great stocks that will substantially outperform is what most market commentators like to write about. Discovering a hidden gem is very satisfying and will help produce exceptional returns, but it is the selling decision that tends to hurt returns far more than sub-optimal buying.
In a recent academic study called "Selling Fast and Buying Slow" the authors studied more than 4 million trades among 783 portfolios managed by professional money managers. The surprising conclusion of the study was that the managers would have increased their returns by nearly 1% if they simply had sold stocks randomly.
These are professions that supposedly use rigorous methods and are not reacting emotionally to price movement yet they would be better off if they threw darts at their list of portfolio holdings when it comes to selling.
The authors conclude that the poor selling is caused primarily by 'asymmetric allocation of cognitive resources' which a fancy academic way of saying that the money managers spend far more time and effort looking to make new buys rather than sells.
That isn't too surprising. Anyone that trades tends to have the same bias as it is much more enjoyable to look for a new idea rather than to make the decision to give up on an old one. We often become emotionally attached to our best performing stocks and are often emotionally inclined to not admit a mistake when we have a poorly acting stock.
My theory for the tendency toward poor selling decisions is that buy points tend to be universal but sell points are much more subjective. A good entry point is pretty much the same for both long-term investors and short-term traders. It really doesn't matter what time frame you are using when you make the initial buy.
The sell decision is the opposite. It is highly dependent on time frame, style and other subjective considerations. Some sellers will focus on technical conditions, some will focus on fundamentals and others will focus on their cost basis and various outside factors. A good sale point for one market player will be a good entry point for someone else.
In most cases poor selling is largely a function of simply not having a plan. We don't really need much of a plan to make good buys but to optimize returns we need to work very hard to devise a strategy for exits.
One interesting note in the "Buy Fast" study is that assets with extreme returns are more than 50% likely to be sold than those that are closer to flat. Impatience to do something becomes much more a factor when we have a stock that is making big moves. We err on the side of action rather than patience when stocks are moving fast
The lesson here is obvious - we must focus much more attention on managing our trades after the initial buy. Rather than constantly looking for the next stock that we want to buy, we have to put more effort into devising a play to handling the stocks we already own.
The two most common selling mistakes are at the opposite ends of the spectrum. Many traders are far too quick to claim a profit when they have one especially when they have had some recent struggles. We want a victory and therefore will rush to ring the register.
At the other end of the spectrum are market players that become 'true believers'. They are emotionally attached to a stock and tend to lose their objectivity about its merits. They often will use Warren Buffet type arguments to justify holding on to a stock.
There is no easy way to address these issues with selling but here are some steps that can help:
- Be self-aware. Once we buy a stock we often forget why we bought it. I have to go through my holdings every day and look at each stock I own and question myself why I am still holding it.
- Have a plan. This is the tough part. We must consider all the various things that can happen and then be ready to put a plan into effect when it occurs. It is nearly impossible to anticipate all the events that might occur but we need to think hard about the possibilities. What if the drug isn't approved or there is an earnings miss?
- Remember that selling is easily reversed. As the "Buy Fast" study shows, professional money managers would produce better returns if they simply sold randomly. They are not using the ability to sell strategically. Small investors can cut their risk at any time by selling and they can add back a position in a blink.
- Use an incremental approach. Rather than trying to time a single buy and a single sell with great precision, use multiple buys and sells to enter and exit. The averaging approach will help you keep the bigger picture in mind and will allow better control of risk.
Selling is never going to be as fun as buying which is way we have to make a greater effort on the sell side. Good buying produces good results but good selling produces great results.