Knowing When to Fold 'em

In his bi-weekly Hot List newsletter, Validea CEO John Reese offers his take on the markets and investing. In the latest issue, John looks at a key but often overlooked part of investment strategy: deciding when to sell.   

Excerpted from the Oct. 26, 2012 issue of the Validea Hot List newsletter

The Missing Piece: Determining When to Sell

Over the past couple weeks, we’ve seen a few big sell-off days in the market. Those disappointing earnings and guidance reports I mentioned above were probably the biggest reason behind the declines, as investors feared it was a sign of a weakening global economy. Lingering fears about Europe’s and China’s economies also played roles.

The sell-offs were thus by and large the result of speculation about macroeconomic factors that triggered emotional responses in investors. We, however — like the vast majority of the gurus we follow — don’t think investors should ever sell based on emotion, macroeconomic factors, or speculation. History has repeatedly shown that such behavior ends up being harmful to an investor’s portfolio over the long haul.

Under what conditions, then, should you sell? It’s a question that doesn’t get nearly enough consideration. In the financial media, selling usually comes up in the context of recommendations about when to decrease your overall stock allocation (usually due to macroeconomic factors), or case-specific examples of why to sell one particular stock. Rarely do you see long-term, broader strategies for selling stocks discussed.

It’s a topic that deserves more airtime. In fact, deciding when to sell can be more difficult than deciding what to buy. Once you own a stock, and it has either risen or fallen, all sorts of emotions start swirling in your mind. It’s the finality of selling that makes it so tough — sell a winner, and you’ll wonder if you’re selling it too soon and missing out on bigger gains; sell a loser, and you’ll fear that it will bounce back strong as soon as you dump it. These kinds of thoughts can lead to emotional decisions that do serious damage to your portfolio.

Selling is such an important — and overlooked — part of the investment process that I dedicated an entire chapter to it in my most recent book, The Guru Investor: How to Beat the Market Using History’s Best Investment Strategies. I think it’s important to review the mindset behind the Hot List approach from time to time, so below I’ve taken excerpts from that chapter that I think best explain our selling approach.

The Missing Piece: Determining When to Sell

While a lot of strategies out there tell you how to buy stocks that will make nice gains, there are few that address the second half of the stock investing equation: when to sell – the proverbial brakes on our car. It’s amazing, really, because for many investors, deciding when to sell is a harder decision than deciding what to buy. Cabot Research, a behavioral finance consulting firm, has found that even top-performing mutual fund managers may be missing out on 100 to 200 basis points per year because of poor sell decisions, Institutional Investor’s Amy Feldman noted in a June 13, 2008 article entitled “Know When To Fold ’em”. Seeing as how amateur investors tend to do much worse than the pros … it’s likely that the average, nonprofessional investor suffers even greater losses because of poor sell decisions.

Part of the reason investors struggle with selling is that advice on the topic is somewhat lacking in the investment world. A survey performed by Cabot and the CFA Institute found that more than 70 percent of professional investors used a selling approach that was not highly disciplined or driven by research and objective criteria, Feldman noted in her piece, so it seems most of the pros aren’t offering a whole lot of guidance here. But another part of why sell decisions are so hard involves an old, familiar foe: our own brains.

Just as our brains tell us to avoid unpopular stocks and jump on hot stocks when we’re buying, they also cause havoc when we’re trying to figure out when we should sell a stock. If you’ve ever put money into the market, you’ve almost surely found this out the hard way.

A few phenomena make selling and sticking to a selling plan a difficult task. For starters, there’s the “fear of regret.” When we make an error in judgment, we feel badly; often, we’ll beat ourselves up with “woulda-coulda-shoulda” thinking, which is never pleasant. And that’s certainly true when we take a loss on a stock. Hindsight is always 20/20, and we end up thinking that we could have easily avoided what turned out to be a bad move. Because of the unpleasantness of those feelings, one theory on why people sell at the wrong time is that they avoid selling stocks that have lost value, instinctively wanting to postpone those feelings of pain and regret, even if those stocks now have little prospect of rebounding.

This is similar to the concept of “myopic loss aversion” that we examined in the previous chapter. In his 1999 paper, “The End of Behavioral Finance,” Professor Richard H. Thaler of the Chicago University explains that loss aversion refers to the observed tendency for decision makers to weigh losses more heavily than gains; losses hurt roughly twice as much as gains feel good. Locking in losses thus hurts a lot so we’ll avoid selling stocks for a loss even after they no longer have good prospects to delay that hurt.

Why are losses so painful? The fact that they are a shot to our egos seems to be part of the reason. Professors Kent Daniel and Sheridan Titman state that people tend to ignore or underweight information that lowers their self-esteem in “Market Efficiency in an Irrational World,” which appeared in the 1999 volume of the Financial Analyst Journal. “For example,” they write, “investors may be reluctant to sell their losers because it requires that they admit to making a mistake, which could lead to a loss in confidence and have deleterious consequences. For similar reasons, investors may systematically overweight information that tends to support their earlier decisions and to filter out information that suggests the earlier decisions were mistakes.” Essentially, we’ll twist the facts to avoid admitting mistakes so that we feel better about ourselves, and our stock-picking abilities. That keeps us from feeling badly about ourselves, but it also keeps us from learning from those mistakes.

Another common mistake many investors make is holding on to winners too long. In his 2001 book Navigate the Noise: Investing in the New Age of Media and Hype, Richard Bernstein notes that growth fund managers often do just that because they are encouraged to do so by all the good news regarding companies’ prospects. A perfect example would seem to be the tech stock boom of the late 1990s. Blinded by the hype, most of those people who had made huge sums of money ignored logic and held on to their stocks too long, only to see them come crashing down.

Selling Smart

So with all of these challenges, how do you stave off emotion and make good, sensible sell decisions? The same way that you keep emotion at bay when deciding what stocks to buy: By using a disciplined system that makes sell decisions based on cold, hard fundamentals, not emotion-driven hunches, or arbitrary price targets. That’s what we’ve done with our model portfolios, as well as with our investment management business, and we think that’s a big reason why the results have been so good.

To understand how and why our sell system works, you have to go back to the basic premise behind our buy strategy. And that is that over the long term, investors gravitate toward stocks with strong fundamentals because those are the strongest companies, and that causes those stocks’ prices to rise over time. We buy because of the fundamentals not just because the price is high or low or rising or falling. Remember, the only way price comes into the decision to buy is in how it relates to the stock’s fundamentals that is, in the form of such variables as the price-sales ratio or price-earnings ratio.

When you’re building your portfolio, then, you want to pick the stocks that have the best fundamentals because (sorry to sound like a broken record) over the long run, investors gravitate toward stocks with strong fundamentals because they are the strongest companies.

Okay, great, you’re saying, but that’s buying stocks; we’ve already covered that. What does this have to do with selling stocks?

Well, it has everything to do with selling. If you’re buying stocks because they have strong fundamentals, and (everyone now), over the long term, stocks with strong fundamentals tend to rise, you should hold on to a stock as long as it continues to meet the fundamental criteria you used to select it. Whether the stock has dropped sharply since you bought it or whether it has skyrocketed is no matter; what matters is where the stock’s fundamentals stand right now. Price, just as with buying, matters only in terms of how it relates to the fundamentals (what the stock’s P/E or P/S ratios are, for example).

Many investors will sell a stock because its price has fallen and they think they need to cut their losses, or because the price has risen and they think the “smart” thing to do is to take the profits rather than risk the stock coming back down. But those are arbitrary, emotional decisions. Remember, you bought the stock because its strong fundamentals made it a good bet to gain value; if its fundamentals are still strong, why wouldn’t it still be a good bet to gain more value?

If the stock’s fundamentals have slipped, however, so that it no longer meets the criteria you used to buy it, it’s time to sell and replace it with another stock that does meet your criteria (and one that thereby has better prospects of rising in value).

The selling assessment is thus an ongoing reevaluation of where a stock stands right now. You must continually reassess what the stock’s prospects are going forward, not what they were a month ago, six months ago, or whenever you bought it.

The next question, then, is what “continually assess” means. Should you check once a day to make sure your holdings still meet your criteria? Once a week? Once a month? Once a year? Since mid-2003 we’ve been running model portfolios based on each of our Guru Strategies. For each model, we’ve constructed separate portfolios that use different rebalancing periods – monthly, quarterly or annually. The model portfolio returns reported at the end of each guru chapter are those of our 10- and 20-stock portfolios using the monthly rebalancing period. On average, this monthly rebalancing tends to produce the highest raw return; the quarterly and annual portfolios, while still ahead of the market, tend to produce less excess return over the time period for which we have results.

The prevalence of inexpensive discount brokerages has made trading very cost-effective today (especially for larger portfolios) and, for many reading this, a monthly portfolio rebalancing is attractive and can be done easily and cheaply with the right online broker. Nevertheless, it’s important to understand that the monthly rebalancing approach does require more a bit more work, time, and commitment. If you’re a busy professional, a retiree who likes to travel or a stay-at-home-mom with young children a less frequent rebalancing approach might work better for you and give you a better chance at following the strategy more consistently. So the important point here, whether you use a one-month rebalancing or a different time frame that works for you, is this — you need to re-examine your portfolio at set intervals, to assess how your holdings stand relative to the reasons you bought them. If they no longer meet the criteria you used to pick them, you should consider replacing them with new stocks that do make the grade.

You can also use your rebalancing period to reweight your portfolio in case some of your holdings have gained or lost a bunch, and now make up a disproportionate part of your portfolio. The idea here is to keep things close to equally weighted. It doesn’t have to be perfect, though; if one stock gains a little ground so that it makes up a few more percentage points of your portfolio than the other stocks, you don’t need to go selling a couple shares and getting hit with trading charges just to even things out exactly. To keep this simple, you might want to set a reweighting target percentage. For example, anytime a holding’s weight in your portfolio becomes 10 percent more or less than your target weight, you buy or sell shares of it to bring it back to that target.

By sticking to a firm rebalancing plan, you keep emotion and hype from impacting your selling decisions. You sell at regular intervals, and you sell based on fundamentals. Just as with buying stocks, there’s no place for hunch-playing or knee-jerk reactions here. There are a couple rare occasions, however, when you should sell a stock without waiting for the rebalancing date to arrive. If a firm is involved or allegedly involved in a major accounting or earnings scandal, you should sell the stock immediately, because you can no longer trust its publicly disclosed financial data. In addition, if a firm has become a serious bankruptcy risk since the last rebalancing, you should also sell its stock immediately.

Nobody’s Perfect

Another thing to keep in mind when it comes to selling stocks is that no investor, not even the greatest investors in the world, are right all the time. Remember what Martin Zweig says: “In the long run, a 60 percent success rate translates into huge gains, a 50 percent rate into solid gains, and even a 40 percent rate can beat the market.” When it comes to the stock market, no one is right all the time or even nearly all the time. Even the great Warren Buffett makes bad investments. Just read Berkshire Hathaway’s annual report, and Buffett will often speak candidly about where he’s gone wrong.

While you’ll never be right all the time, you can be right more than you’re wrong, however. In the end, the key is to develop a fundamental-based selling and rebalancing plan and stick with it, no matter what. When your portfolio does lose ground from time to time, you’ll inevitably feel the urge to sell certain stocks and go after others on a whim or a hunch to make up ground. But if you have a detailed, quantitative selling system in place, you can help keep short-term emotions from wreaking havoc with your long-term performance.