The majority of stock advice articles we read are about which shares we should or shouldn't buy.
But selling is just as critical, since that's when losses or gains are actually realised.
"Selling is as important to investing as braking is to driving," Lumenary managing director Lawrence Lam posted on Livewire.
"Yet all too often, investors only know the accelerator and gloss over the analytical framework of selling. In doing so, they give up much of the hard work they have put in to establish the buy thesis."
Lam added that selling is a difficult art that even professional investors are clumsy at.
He cited a recent University of Chicago study that showed poor selling was killing performance among institutional investors.
"So bad were the selling decisions they even failed to beat a random selling strategy," said Lam.
"These weren't retail investors. The study looked at portfolio managers with an average US$600 million size. The outcome? They still failed to outperform a simple randomised strategy."
Why is everyone so bad at selling?
The reason is that humans use what are called "heuristics" to make decisions.
These are mental shortcuts that allow us to function in a world that demands complex choices be made each and every day.
The result is that we can make decisions faster and with less stress, but the solution is not necessarily optimal.
Usually, this serves us well — like when deciding which breakfast cereal to have in the morning.
But for an activity that requires complicated analysis like deciding which shares to sell and when, heuristics can cause poor outcomes.
Lam quotes three common heuristics that cause investors to dispose of their shares poorly:
- 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"
Lam said these cognitive biases can cause one of two outcomes.
"First, you can sell out of a great company too early," he said.
"Second, a weakness in your selling process can lead to prolonging a losing investment far too long. Our cognitive biases can shroud our judgement. We can become committed to a previous decision and fail to see how changing circumstances no longer make an investment worthy of our portfolios."
Easier said than done
Times of market crashes are especially hard on our ability to think clearly about selling shares.
Instead of judging a business on its merits, investors become price-reactionary, according to Lam.
"When you're facing a 30 to 40% drop in prices, the stomach will take over the mind. Stress sets in, sometimes even panic," he said.
"Heuristics invade the decision-making process when time is pressured. Evidence points to the most severe underperformance on sales coming after extreme price movements."
Professionals are actually more susceptible to rash sell-offs during market corrections, as they have to regularly report back performance to their clients.
"They tend to use stop-losses, automatic rebalancing to benchmark weighting, and auto profit-taking triggers to simplify sell decisions."
Lam said selling a share must always be on the basis of changes in a company's prospects.
