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Eight quick lessons on the intricacies of selling shares

When we think about investing, we always think about buying. We spend enormous amounts of time forecasting the future and distilling vast stores of information into one single click of a green button.

But what is commonly overlooked, is the other side of the equation - selling. It remains the poor cousin of buying, yet it shouldn’t be. Selling is as important to investing as braking is to driving. But investors are speed demons. They glamourise the accelerator. In doing so, they give up much of the hard work they have put in to establish the buy thesis.

A surprising fact about institutional investors

It may surprise you to know institutional investors do not have an edge when it comes to selling. Recent researchers studied the outcomes of selling decisions and determined there was substantial underperformance over the long-term. So bad were the selling decisions they even failed to beat a random selling strategy. These weren’t retail investors. The study reviewed professional investors averaging US$600 million in funds under management.

What can investors learn from the mistakes of institutions?

1. Poor selling and ways it can hurt

Without an analytical framework for selling, investors use mental shortcuts which are susceptible to behavioural biases and lead to inconsistent results. Poor selling can hurt in two ways:

First, you can sell out of a great company too early. The seed of a Californian redwood tree is only a tiny speck, yet it has great potential beyond its appearance. Dispose of those seeds and you miss out on a giant.

Second, a weakness in the selling process can lead to prolonging a losing investment far too long. Cognitive biases can shroud judgement. We become committed to a previous decision and fail to see how changing circumstances no longer make an investment worthy.

2. Use heuristics carefully

Earlier I introduced the term ‘mental shortcuts’. In psychology, these are known as heuristics. They’re good for simple decision making, but detrimental when it comes to complex analysis required for investing. Without a system of thought, we gravitate back towards a structureless approach. And this is where it can go wrong for many sellers.

Even at the institutional level, cognitive biases creep in. Research found the most common being:

  • The disposition effect: a reluctance towards selling losers, and inclination to selling winners.
  • Overconfidence: assuming you will make the right decision to sell without any factual analysis.
  • Narrow bracketing: looking at decisions in isolation without consideration for the broader picture. Analysts who focus on one geographic or sector are most susceptible to this.

This makes sense. Financial incentives of institutional investors are centred around investment prowess, not divestment skill, and individuals can outmanoeuvre institutions.

3. Easy come, easy go

Poor selling is correlated to a lack of conviction. If you don’t have strong conviction buying into a stock, it will show in your sell decisions. This conviction when entering a stock also translates to better selling performance on exit. Think about those stocks representing the smallest proportion of your portfolio. These are the stocks you are most likely to make bad sell decisions with.

Dipping toes in waters is not the optimal way to invest. Concentration leads to outperformance as it encourages deeper analysis. Nothing like a big investment to ward off capriciousness. The benefit isn’t only on the buy side.

4. Knee-jerks hurt

One of the main reasons institutional investors make bad selling decisions is because they react to price movements. All the fundamental analysis done when deciding to buy is not mirrored when they sell. Instead, sell decisions are either automatically triggered via stop losses or auto-rebalancing strategies to capture recent gains. Either way, basing selling decisions purely on price is what leads to underperformance.

To counter a pure price focus, investors can change perspective with these mindset-centring questions:

  • Have business prospects fundamentally changed for the future?
  • Are customers migrating away from this industry?
  • Does the company still retain its competitive edge?

5. Following the time of year

Calendar trades occur when professional fund managers decide to sell for no other reason than to realise taxable losses or crystalise their gains as they massage their financial year end results. Annual bonuses drive selling decisions which are proven to underperform in the long-term. From the portfolio manager’s perspective, it may not matter if they are rewarded for these decisions so long as they achieve their end of financial year KPIs.

Knowing these weaknesses is one thing, mitigating them is another. It is only once these issues become known that addressing them becomes possible.

6. Incentives create value

The single hardest and simplest correction for most investors is to align your long-term incentives with your selling strategy. If your investment strategy is long-term and you want to compound your investments, then set up a framework that rewards careful, fundamental analysis before selling. 

The same questions when buying should be applied to selling. Here is where private investors have an in-built advantage over institutions. They should innately possess the flexibility and natural incentive to perform over the long-term.

Institutional managers need to think as if they are the largest investor in their fund.

7. Stress and other suboptimal influences

When you’re facing a 30-40% drop in prices, the stomach will take over the mind. Stress sets in, sometimes panic. This pressure is even greater for institutions who have to report back to thousands of clients. They become price-reactionary. Heuristics invade the decision-making process when time is pressured. Evidence points to the most severe underperformance on sales coming after extreme price movements.

When your gut is telling you to sell, think back to the mindset-centring questions above.

8. Creating a feedback loop

Institutions spend less time analysing the selling decision. They will meticulously track buying decisions, but they rarely analyse how selling decisions went. A technique I employ to improve selling decisions is to elucidate myself with iterative feedback. Track the results of selling decisions just as you would with buying decisions. Each iteration of feedback informs how a sell decision can be improved for next time. Without it, investors are blind to their own mistakes.

Evolving your selling

The evolution of any investor understandably begins with focusing on buying, but sophisticated investors that truly understand when and how to sell, transcend into becoming adaptive investors able to compound wealth in any market condition. Adaptive capital is where you ride each wave as it presents itself. To do that, you need to be skilful at braking, not just accelerating.

Happy compounding.

 

Lawrence Lam is Managing Director and Founder of Lumenary, a fund that invests in the best founder-led companies in the world. The material in this article is for general information only and does not consider any individual’s investment objectives. All stocks mentioned have been used for illustrative purposes only and do not represent any buy or sell recommendations.

 

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