Our brains rebel when we attempt to sell our losers, but good investors learn to take emotions out of the equation, writes John Reese of the Validea Hot List.
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.
Research has shown that even top-performing mutual fund managers may be missing out on a percentage point or two per year because of poor sell decisions. 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 timing.
Part of the reason investors struggle with selling is that advice on the topic is somewhat lacking in the investment world. One survey showed that more than 70% of professional investors used a selling approach that was not highly disciplined or driven by research and objective criteria. 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.
Meet the Enemy
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.
According to Professor Richard H. Thaler of the University of Chicago, losses hurt roughly twice as much as gains feel good. So we'll avoid selling stocks for a loss, even after they no longer have good prospects to delay that hurt.
Another common mistake many investors make is holding on to winners too long. 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.
Next: Selling Smart
|pagebreak|Selling Smart
So with all of these challenges, how do you stave off emotion and make good, sensible sell decisions? The same way 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.
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 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.
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
Not even the greatest investors in the world are right all the time. Remember what noted investor Martin Zweig says: "In the long run, a 60% success rate translates into huge gains, a 50% rate into solid gains, and even a 40% rate can beat the market."
Even the great Warren Buffett makes bad investments. Just read Berkshire Hathaway's annual report. 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. 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.
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