Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 403

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.

 

banner

Most viewed in recent weeks

10 little-known pension traps prove the value of advice

Most people entering retirement do not see a financial adviser, mainly due to cost. It's a major problem because there are small mistakes a retiree can make which are expensive and avoidable if a few tips were known.

Check eligibility for the Commonwealth Seniors Health Card

Eligibility for the Commonwealth Seniors Health Card has no asset test and a relatively high income test. It's worth checking eligibility and the benefits of qualifying to save on the cost of medications.

Hamish Douglass on why the movie hasn’t ended yet

The focus is on Magellan for its investment performance and departure of the CEO, but Douglass says the pandemic, inflation, rising rates and Middle East tensions have not played out. Vindication is always long term.

Start the year right with the 2022 Retiree Checklist

This is our annual checklist of what retirees need to be aware of in 2022. It is a long list of 25 items and not everything will apply to your situation. Run your eye over the benefits and entitlements.

At 98-years-old, Charlie Munger still delivers the one-liners

The Warren Buffett/Charlie Munger partnership is the stuff of legends, but even Charlie admits it is coming to an end ("I'm nearly dead"). He is one of the few people in investing prepared to say what he thinks.

Should I pay off the mortgage or top up my superannuation?

Depending on personal circumstances, it may be time to rethink the bias to paying down housing debt over wealth accumulation in super. Do the sums and ask these four questions to plan for your future.

Latest Updates

Investment strategies

Three ways index investing masks extra risk

There are thousands of different indexes, and they are not all diversified and broadly-based. Watch for concentration risk in sectors and companies, and know the underlying assets in case liquidity is needed.

Investment strategies

Will 2022 be the year for quality companies?

It is easy to feel like an investing genius over the last 10 years, with most asset classes making wonderful gains. But if there's a setback, companies like Reece, ARB, Cochlear, REA Group and CSL will recover best.

Shares

2022 outlook: buy a raincoat but don't put it on yet

In the 11th year of a bull market, near the end of the cycle, some type of correction is likely. Underneath is solid, healthy and underpinned by strong earnings growth, but there's less room for mistakes.

Gold

Time to give up on gold?

In 2021, the gold price failed to sustain its strong rise since 2018, although it recovered after early losses. But where does gold sit in a world of inflation, rising rates and a competitor like Bitcoin?

Investment strategies

Global leaders reveal surprises of 2021, challenges for 2022

In a sentence or two, global experts across many fields are asked to summarise the biggest surprise of 2021, and enduring challenges into 2022. It's a short and sweet view of the changes we are all facing.

Shares

What were the big stockmarket listings in record 2021?

In 2021, sharemarket gains supported record levels of capital raisings and IPOs in Australia. The range of deals listed here shows the maturity of the local market in providing equity capital.

Economy

Let 'er rip: how high can debt-to-GDP ratios soar?

Governments and investors have been complacent about the build up of debt, but at some level, a ceiling exists. Are we near yet? Trouble is brewing, especially in the eurozone and emerging countries.

Sponsors

Alliances

© 2022 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. Any general advice or ‘regulated financial advice’ under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.

Website Development by Master Publisher.