Welcome back and thank you for sticking with it! Beats shopping for a washing machine but most people spend more time doing that than they do trying to do better with their investments. Anywho, let’s now pivot the conversation towards the slippery “when to sell?” question. The first part of our talk will cover some applicable behavioral considerations and we will discuss more quantitative tenets in the latter part.
“Ok, so I am up something like 67% on XYZ Inc. but it is starting to roll over on me. The last quarter missed pretty bad and management is making some confusing strategic changes. I also took that hit locking in a 34% loss earlier in the year on ABC LLC? Should I protect the gain in XYZ and offset the loss a bit for my taxes? I probably should. Yet, XYZ still makes the grade and has been so good to me over the years. It’s just so hard to sell now. It was $112 per share earlier in the year and it is $91 per share currently. No, I can’t sell it here.” – My inner thoughts at some point 20 years or so ago I am sure.
There is so much wrong with the brain vomit above. It is short-sited and much of that twaddle doesn’t matter. What matters? i) “XYZ still makes the grade”; ii) “it is starting to roll over”; iii) last quarter missed “pretty bad”; and iv) “confusing strategic changes”. What does not matter? i) how much you are up on XYZ; ii) what your other gains/losses look like; iii) that $112 reference high point; and iv) that “XYZ has been good to you” (although this is the lesser evil).
Bias is a reality of human decision making. We generally have these tendencies to help us make more efficient decisions. Though, not necessarily optimal decisions. The good news it that you likely only make irrational choices once in a while. The bad news is you usually can’t trust yourself to know if you are.
I should note a couple things before we proceed. Firstly, many of behavioral biases are closely related to one another and the differences in how these biases are defined can be subtle. Investors guilty of one form of bias are often then also guilty of others. Secondly, we assume here that the position(s) in question meets the requirements for investment. If not, it better be clear to you that you are speculating and/or holding a short term trade. Otherwise, it is a pretty simple call – hit the sell button.
Behavioral Trappings – The first bit below covers common behavioral trickery we need to be hip to before getting serious about selling. Then we get into the fundamental weapons check before triggers get pulled.
Mental Shenanigans Checklist
Loss Aversion – People hate losing money a lot more than they enjoy making it. Perhaps, part of the reason is you had to earn those after tax dollars first. Accounting for gains and losses differently will nevertheless undoubtedly skew your perspective to the negative. For example, say an investor made 20 $100 investments in a given year and reviewed them at yearend. 3 of the trades had gained $25, 7 of the trades generated a return of $15, 3 trades netted $5, and 3 produced a loss of $5, 2 netted a loss of $10, 1 a loss of $15 and 1 a loss of $25. It is not uncommon for this investor to fixate on these top few losing positions – down 10% to 25% – and unknowingly reduce their risk tolerance towards future investments (and thus their likely return potential).
Disposition Effect Bias – Are you unwittingly labeling a position as a winner or loser? We can be prone to selling winning positions too early and hanging onto losers too long when we do. Sometimes, we sell winners early to offset past losses to settle a mental account we may not even realize we are keeping. Even Warren Buffet called the old adage ‘you never go broke taking a profit’ foolish advice.
We actually tend to be most risk averse when dealing with gains and most risk seeking with losses. Don’t fool yourself into thinking you don’t do this as well – e.g. ever added to a position because it went down so low you felt it was the only way to recoup your losses?
Anchoring / Reference Point Bias: You bought ABC corp at $25 per share, it hit $31 per share but it is $19 per share now on weakening industry fundamentals. Man, you wish you could just get your money back and be done with this one. Two things. One, the market does not care what you paid for your position. Not even a little. And, if you don’t wake up soon, it may not care all the way down to $13 per share. But let’s humour ourselves. Say ABC does recover to $25. You know what you are probably going to do? Shoot for $31. You know how much smarts are in that? The square root of zero. Be ye careful of anchoring / reference point bias.
Endowment Effect: Investors often place more value on investments they currently own than they would if they had the same knowledge of / familiarity with a position, but didn’t yet own it. Sellers consequently often put an irrational selling price premiums on owned assets. I would see this when one company was sold to another public company in a share exchange transaction. Many of the selling company’s senior management (i.e. not taking employment at the purchaser company) would commonly hold all or much of their new concentrated stock position well after the deal had closed. However, there is pretty much a 0% chance they would have gone out an bought this amount of stock if the deal had been all cash. It is not worth more just because you already own it.
Technically Speaking – When to Sell
Selling discipline very much depends where you are in a market cycle. Unless you work at Renaissance Technologies or the like, prepare yourself for art not science class.
Selling sensitivity should be heightened after a rapid increase in volatility following a long period of low volatility, high real returns and consistent monetary stimulus. If the market is correcting in this scenario, program trading algorithms will likely make it worse. Inversely, net on net, an investor should be less sensitive to negative volatility after the market has already corrected materially.
Selling does not necessarily mean you are abandoning the company and its prospects however. It does not have to be binary. You can always reinvest. You can also reduce exposure without selling out completely, or slowly average out of a position over time.
I have three general guidelines to help determine when to sell at all:
Is the asset visibly over-valued AND trending down? – This is a very important “AND”. Expensive assets are habitually also the most popular and can reach higher highs than valuation fundamentals suggest agreeable; and/or
Has there been a material adverse change in the risk profile of the investment? – This can be company specific or a broader market change in risk; and/or
Is there a material opportunity cost of capital? – If I am fully invested and a preferable risk / reward opportunity presents itself (i.e. relative to an incumbent position), oftentimes, I should sell and buy into the more compelling new opportunity.
Specific to the second point, selling losers, like buying winners, requires identification of the cause and a determination of its continuance. Small losses can frequently turn into bigger losses, and, as we discussed, stubbornly hanging on to losing positions can foster costly negative biases toward future opportunities. Most of the most successful entrepreneurs I have had the pleasure of witnessing also know that you need to leave some meat on the bone for the buyer. Novices try to suck out every last drop of blood and hit the top of the market on every deal. Do win / win deals and you will grow much wealthier and foster much more meaningful relationships.
Lastly, be very leery about selling out of class ‘A’ assets over concerns of macro risk (i.e. non-company specific) or short-term under-performance. At the very least, try to think hard about what the dominating force is – the macro risk or the quality of the company. Selling out of amazing businesses too early have been my most costly investment mistakes.
Making It Happen 
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