Tuesday, 23 June 2009

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.

  • For many investors, deciding when to sell is a harder decision than deciding what to buy.
  • Cabot Research, a behavioural 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.
  • Seeing as how amateur investors tend to do much worse than the professionals, it is likely that the average, nonprofessional investor suffers even greater losses because of poor sell decisions.

Why are investors struggling with selling?

  • Advice on this topic is somewhat lacking in the investment world. A survey found that more than 70% of professionals 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.
  • 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.

A few phenomena make selling - and sticking to a selling plan - a difficult task.

- There's the 'fear of regret."

When we make an error of judgment, we feel badly; which is never pleasant. This is 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, the investor 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.
  • 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."
  • As locking in losses hurts a lot, investors 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.

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.
  • Many investors - professional and amateur, made a fortune as the Internet bubble grew. The problem was that the bubble kept growing, long, long after these stocks had risen above reasonable values.
  • Still the buzzs was that the "Internet Era" had arrived, and would fundamentally change the stock market; when it came to the World Wide Web, the theory went, there were limitless possibilities - and thus limitless returns.
  • 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.

To try to avoid some of these problems, some people will set price targets for stocks they buy.

  • They'll determine ahead of time that, if the stock gains, say 30%, they will sell it and take the profits. This sounds good on the surface, but really it's just another problem.
  • All gaining stocks were not created equal; one stock may gain 30% and then drops, but another may gain 30% and then gain another 200%.
  • Setting arbitrary selling targets like this can hurt just as much as they help, if not more.

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