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  1. Home
  2. / Investing

Why Selling Stocks at Random Produces Better Returns

It is managing the trade and deciding when to reduce positions that impact results far more than anything else.
By JAMES "REV SHARK" DEPORRE
Sep 14, 2019 | 10:00 AM EDT

Most discussion about the stock market is focused on market timing and finding good stocks to buy. There is very little discussion of the selling decision. When selling is discussed it is usually in the context of overall market conditions and whether a major top is forming rather than based on the merits of individual stocks.

A recent academic study entitled "Selling Fast and Buying Slow: Heuristics and Trading Performance of Institutional Investors", written by researchers from the University of Chicago, Carnegie Mellon and MIT compared buying decisions with the selling decisions of institutional investors.

The authors concluded that, on average, fund managers would produce better returns if they simply sold stocks in their portfolio at random. "We document a striking pattern: while the investors display clear skill in buying, their selling decisions underperform substantially."

The main reason for this is that managers tend to sell when they are forced to due to market conditions rather than by studying individual stocks. The first stocks that managers tend to sell are those that have made the most extreme moves in either direction. They sell the big losers or the big gainers at a 50% higher rate. Selling in this manner tends to be a mistake.

When portfolio managers focused on company-specific information, they were able to improve their selling decisions substantially. When selling to simply raise cash or reduce market exposure the decisions were suboptimal.

This past week we saw a very sharp rotation out of momentum and expensive stocks and into value names. This is the sort of selling that tends to be based on poor decisions because it is primarily selling to simply raise cash for the next buying idea.

There are some important lessons for individual traders and investors in this study:

  1. Have a plan for selling. This is by far the best action to take but there is a strong inclination to not think about selling until we are forced to. Rather than systematic dealing with the big swings that are inevitable, we react emotionally and strategy goes out the window. Make sure your selling is based on logic rather than emotions.
  2. Be proactive about selling. Many market players try to avoid the selling decision. They view it as a monumental decision rather than something that can be quickly and easily reversed. Just because you sold a stock at a lower price yesterday doesn't mean you can't rebuy it today.
  3. To produce better returns, focus more energy on selling. Buying is the easy part of a trade. It is managing the trade and deciding when to reduce positions that impact results far more than anything else.
  4. Substantially reducing positions on a random basis can be a helpful way to reset your emotions and the way you view the market. It can be quite helpful to start with a clean slate periodically as it will alter your perception of the market substantially.

Buying a new stock with high expectations is the fun part of trading but it is the work of selling that stock in a timely manner that will determine our level of success.

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At the time of publication, James DePorre had no position in the securities mentioned.

TAGS: Investing | Markets | Stocks | Trading

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