The Key to Great Returns Is Not Buying, but Selling

The majority of trading and investing advice focuses on the buying decision. Most market commentators like to write about finding great stocks that will substantially outperform. People want to hear about the next great stock, rather than about selling an old one. It is very satisfying to discover a hidden gem and ride it, as it produces exceptional returns, but deciding when to sell determines success to a far greater degree than the decision of what and when to buy.

In an academic report entitled "Selling Fast and Buying Slow," the authors studied more than 4 million trades in 783 portfolios managed by professional money managers. The conclusion of the study was that the managers would have increased their returns by about 1% if they had sold stocks at random. These are professional investors who 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 concluded that poor selling is caused primarily by the "asymmetric allocation of cognitive resources," which is a fancy academic way of saying that money managers spend far more time and effort on making new buys rather than sells.

That isn't too surprising. Anyone who 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 inclined not to admit a mistake when we have a poorly acting stock. Rather than wrestle with what to do with a position, we just look for something new to buy instead.

Good buy points are much easier to determine than good sell points. 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 due to a lack of a plan. We don't really need much of a plan to make good buys, but to optimize returns, we need to devise a strategy for exits. Selling is the best way to control risk, but it is underutilized for that task.

One interesting note in the "Buy Fast" study is that assets with large returns are more than 50% more likely to be sold than those that are closer to unchanged. Impatience to do something becomes much more of 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: to improve your trading, it is necessary to focus much more on managing 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 plan to manage 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 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 use Warren Buffet-type arguments to justify holding on to a stock. The end result for investors is that they ride their losers and cut their winners, which is the opposite of what they should be doing.

There is no easy way to address these issues with selling, but here are some steps that can help: Be self-aware. Once you buy a stock, it is easy to forget why you bought it. I go through my holdings every day, look at each stock I own, and ask why I am still holding it and whether I want to adjust my position size.

Remember that selling is easily reversed. There is nothing to stop you from rebuying a stock that you have sold. I find that selling and rebuying is one of the best ways to manage my emotions. It helps to shake off inertia and gives confidence that I am in control of the trade.

Investors will always spend more time and energy on buying because of the promise of riches to come. Selling is the end of the dream, so it tends to be ignored, but it is what will determine your ultimate success more than anything else.

At the time of publication, DePorre had no positions in any security mentioned.