When to Sell
Tuesday, August 01, 2017
There is a lot of literature about when to buy a stock, but little about when to sell. This is odd, because for every buyer there is a seller and selling a stock at the right time can have significant influence on portfolio returns.
The decision to sell a stock is the same as when to buy; it’s part art and part science. The selling discipline involves a blend of human judgment (art) tempered by a quantitative system (science). At minimum, the science requires a basic understanding of finance, accounting and arithmetic. However, we believe investing in stocks is more art than science, and people trained to rigidly quantify everything are at a big disadvantage. The extreme swings in investor psychology often provide market-beating investment opportunities.
Benjamin Graham, the father of value investing, referred to human psychology when he said, “An investor’s chief problem, even his worst enemy, is likely himself.” He observed that, “the market is fond of making mountains out of molehills and exaggerating ordinary vicissitudes into major setbacks. Even a mere lack of interest or enthusiasm may impel a price decline to absurdly low levels.” When most people’s gut reaction is to sell, it’s a good time to ask whether the facts or emotion are driving the price and consider buying.
In general, we believe there are three reasons to sell a stock:
The Switch: Funds are required for a higher-quality, better-priced idea, and/or a security with more suitable risk/reward characteristics. This is the most frequent reason we sell a stock.
Misjudgement: When it becomes apparent that the investment thesis is wrong. Common mistakes include misjudging the competitive advantages of a company, the future economics of the industry in which it operates, and/or the strength of the management team.
Overvaluation: When the market judges a business to be more valuable than the underlying facts indicate. Because we don’t believe in market timing, we tend to switch overvalued stocks for those that are more attractively priced.
The easiest sell decision, and the one we recommend the most, is the switch from one business to another with better risk and reward characteristics. Because time in the market matters a lot more than market-timing, the most successful investors tend to focus on owning the best businesses for the long term.
Thoughtful investors appreciate that we all make mistakes. The world is constantly changing. As the facts change, so does an investment’s underlying value. If we can admit our misjudgments, make a rational decision and move on, it will help to improve our future investment returns. Investors need to be critical and have the ability to part with stocks when circumstances change.
Some people automatically sell their winners and hold on to their losers. Famed investor, Peter Lynch, calls this approach as sensible as “pulling out the flowers and watering the weeds.” Other investors automatically sell their losers and hold on to their winners. Both strategies fail because they are tied to the current movement of the stock price, which is not an indicator of a company’s fundamental value. The underlying fundamentals and valuation of the business, not the action in the stock price, should drive one’s commitment to an investment.
People who have a tendency to hold on to their losing stocks might suffer from get-even-itis, which occurs when investors get psychologically anchored to the stock price they originally paid. It’s human to abhor admitting mistakes and many investors therefore resist a sale until they can get even with the original purchase price. Unfortunately, this is a major contributor to portfolio underperformance. It’s the future that matters.
If raising cash is a priority we generally lean toward selling a misjudgement before selling due to overvaluation. Investors often regret selling a great business when it gets temporarily pricey, because they often fail to buy back in and enjoy the long-term growth of the business.
The key to preserving and growing wealth is buying and holding great companies. A good sell discipline is integral to knowing what businesses to stick with for the long term.