Buy for Show, Sell for Dough
It is the 'selling' decision that will determine your investing success to a far greater degree than the 'buying' decision.
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The vast majority of investing is focused on the buying decision. Uncovering the next great stock is a thrilling adventure, and if the right decision is made, then there is the likelihood of substantial profits. Investors are always hunting for the next Apple (AAPL) or Nvidia (NVDA) . It is no surprise that the business media seldom mentions selling.
But while buying is the primary focus of investing, the selling decision is much more important and powerful. The decision to sell will determine your success to a much greater degree than buying.
It is inevitable that in the search for the next outstanding stock, there will be many mistakes and errors. Almost all stocks have a limited time period in which they will produce superior returns. If investors fail to sell their mistakes or exit underperforming stocks effectively, they will offset much of the benefits of good stock picking.
Buying is the enjoyable aspect of investing, whereas selling requires the hard work and discipline. As a result, the sell decision is not as carefully considered, and there is a tendency to avoid it until we are forced to confront it. Selling often becomes an emotional decision when caught off guard by market events.
Buying is the enjoyable aspect of investing, whereas selling requires the hard work and discipline.
Trading and investing in stocks is quite simple in theory. Buy good stocks, manage your position, and then take your profits and move on. Market participants tend to be pretty good at buying and holding, but they do a lousy job of selling.
It's easy to see why there's little focus on selling. Everyone loves discussing the top-performing stocks that will make them rich. Few people want to dwell on selling their poor picks and giving up on longer-term winners.
Like most things in life, it is the complex or unpleasant tasks that will determine success more than anything else. Selling is the necessary evil that, if we address it effectively, will have an outsized impact on our results.
Because selling is not a decision that is approached in a systematic way, the decisions tend to be more emotional. We spend the majority of our time focusing on the next great trade, and when we have to deal with selling, we make emotional decisions and quickly move on.
'Selling Fast and Buying Slow'
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 found that, on average, fund managers would produce better returns if they 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."
That is a shocking conclusion. Professional money managers add no value to the decision to sell? They might as well just flip a coin or use astrology when making the decision to dump a stock?
The study concluded that the main reason for this is that managers tend to sell when they are forced to do so due to market conditions. They lack a systematic approach to selling, instead making decisions only when they have no choice, and these decisions are driven mostly by emotional factors.
The first stocks that most fund managers sell are those that have made the most significant moves in either direction. They sell their big losers or big gainers at a 50% higher rate than other stocks, as these are the ones that evoke the strongest emotional responses.
By focusing on fundamentals and company-specific information, portfolio managers were able to improve their selling decisions substantially. When selling was driven by the desire to raise cash or reduce market exposure, the decisions were suboptimal.
Key Lessons for Individual Traders and Investors
There are some important lessons for individual traders and investors in this study:
Have a plan that explicitly addresses selling. This is by far the most important thing you can do, but there is a strong inclination not to think about selling until you are forced to. Rather than systematically deal with the big swings, we react emotionally, and strategy goes out the window. Panic selling isn't always a mistake, but it often leads to abysmal timing. Make sure your selling is based on logic rather than emotions.
Be proactive about selling. Many market players try to avoid the selling decision. They view it as a monumental choice 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. Even though selling is very easy to do and undo, there is a strong emotional resistance to it for various reasons. Overcoming this view of selling will help your trading more than anything else.
To produce better returns, focus more energy on selling. Buying is the easy part of a trade. It involves managing the trade and deciding when to reduce positions, which has a far greater impact on results than anything else.
Focus on how to use selling to aid in positioning. It is a powerful strategic tool that can help you enhance a bullish trade, but allows you to time when you want to be more aggressive. I constantly buy and sell positions, adjusting their size as I wait for them to set up. Even though I'm convinced the stock will work over time, I will cut it back during a low period so I can be even more aggressive when the time is right.
Substantially reducing positions on a random basis can be a helpful way to reset your emotions and the way you view the market. It is helpful to start with a clean slate periodically, as it will alter your perception of the market substantially. It is always surprising how your view of the market will shift when you aren't wrestling with stocks that aren't cooperating.
Buying a new stock with high expectations is the fun part of trading, but it is the work of effectively selling a stock that will determine your level of success more than anything else.
At the time of publication, Rev Shark had no positions in any securities mentioned.
