March 30, 2010
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The emotional weight that often accompanies selling a stock can contribute to selling it poorly. Here’s a framework for making the sell decision as rigorous and analytical as the decision to buy.
Take a look at any investment manager’s website or pitch book and virtually all the discussion about strategy focuses on buying. Selling is typically addressed separately, as a component of the manager’s “discipline.” That distinction – buying is strategic and selling disciplined – says a lot about the energy and resources that are allocated between these two critical activities. The relative emphasis is clear elsewhere: While bookstore and business-school library shelves are brimming with books about how to buy stocks, little or no attention is paid to selling. Scholarly papers and trade-publication articles regularly address in minute detail how to buy, while almost never exploring the strategic aspect of selling or even referring to selling as a skill.
People are hard-wired to like buying more than selling. “It has to do with our preference for positive, future events,” says Terrence Odean, a behavioral-finance expert who is a Professor of Finance at the University of California at Berkeley. “Buying is optimistic, about what the stock can do for the portfolio going forward. Selling is generally more pessimistic, about what the stock has already done to the portfolio, which may or may not have been pleasant.” As a result, investors – consciously or unconsciously – derive more pleasure from buying than from selling.
Because selling can be so emotionally loaded, it can trigger a variety of ineffective behaviors, including:
Risk Aversion. This is the tendency to sell winners too quickly, well before these successful stocks have delivered their full alpha to the portfolio. Motivating these quick sells is the fear that, rather than the stock continuing to outperform, it might experience an abrupt price reversal, the result of which would be giving hard-earned gains back to the market.
Loss Aversion. This is the tendency to hold on to losers far too long. It is typically supported by a narrative about a likely turnaround, but more often than not its true purpose is to enable the manager to avoid feeling badly over realizing a loss. In a sense, when a losing position is sold, it remains a loser forever in the manager’s mind, taking with it perhaps a little of the manager’s confidence as well.
The Endowment Effect. This is the tendency to hold positions well beyond their productive life. Research indicates that mere possession of an item causes its perceived value to rise above the level at which the owner would have been a willing buyer before he or she owned it. Selling “endowed” possessions can therefore become difficult, as the owner chronically values them more highly than does the market. Such behavior can lead to the well-known phenomenon of round-tripping – a trip best avoided.Display article as PDF for printing.
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