Just after New Year, an amazing paper was posted on SSRN called “Selling Fast and Buying Slow: Heuristics and Trading Performance of Institutional Investors.” A few days later, Matt Levine, who writes daily for Bloomberg and whom I read almost religiously, published a terrific column about it called “Investors Have to Sell Stocks Too.” They’re both worth reading in full. But I’ll tell you about this new research in case you don’t feel inclined to navigate away from this page.
Basically, the paper found that professional investors—portfolio managers—put a lot of thought and effort into what stocks to buy, and they’re very good at choosing them. The stocks they buy tend to perform much better than if these managers had simply picked stocks at random. However, when it comes to selling these stocks, portfolio managers basically have no idea what they’re doing. If they had just trained monkeys to throw darts at their portfolios, they’d perform considerably better. How much better? By over 1% per year. And that really adds up. Training monkeys to throw darts is considerably cheaper.
Portfolio managers tend to sell stocks based on astrology. Just kidding. Actually, they base their decisions on price performance, which is almost as bad. The study shows that stocks that have performed extremely well or extremely badly are those most likely to be sold (actually, 50% more likely!). This is the exact opposite of what these managers do when they choose stocks to buy. When buying stocks, portfolio managers look at the fundamentals, not at price performance. But when choosing which stocks to sell, fundamentals go out the window. Instead these managers seem to rely on silly heuristics like “sell your losers and let your winners run” or “sell if you double your money” or “sell your most volatile holdings.” It doesn’t take a lot of savvy to realize that these “rules,” if strictly followed, would rather quickly bankrupt almost any investor.
Value investing has always focused on finding bargains to buy, not on choosing holdings to sell. There are many good psychological reasons for this emphasis. For one thing, buying things is always more fun than selling them. Think of all the things you’ve bought in your life that you probably should sell but haven’t. Buying is an act of optimism—you’re meeting a new friend, looking forward to future gains. Selling is an act of pessimism—you’re saying goodbye to an old friend, abandoning a once-promising prospect. As a result, most investors base their decision to sell on gossip, a hunch, or a drastic move in price.
But your overall performance as an investor is going to be based not only on knowing what stocks to buy and when, but also knowing when to sell them. It’s essential to develop a reasonable and successful strategy for doing so.
I have only two rules for selling stocks, and they’re both rather simple. By sticking to these rules, I’ve kept my CAGR at 40% or higher for more than three years now.
Rule #1: never sell a stock unless you need the cash for another investment. Even if it has failed to live up to your expectations or has posted a terrible earnings report, if you have nothing to replace it with, hold it.
Rule #2: rank all your holdings before you sell. Either sell the ones with the lowest rank, or diminish the number of shares you own of the stocks whose weight is out of proportion to their rank.
To implement this second rule, think of all the factors that motivate you to buy a stock. Make a list of them, even if it’s a long one. It could be its P/E ratio or its EV/EBITDA. It could be a recent price and volume move, or a terrific earnings report. Maybe it’s an innovative CEO or even a tip from a trusted friend.
Now rank all your stocks according to each of these factors, and add up the ranks. Some of your holdings should rank quite a bit higher than others.
At this point, you have two options. You can simply sell the lowest-ranked stock. Or you can build an upside-down ideal holding pyramid, in which the highest-ranked stocks have the greatest portfolio weight. You can then adjust your holdings by buying and selling to better conform to that ideal.
There are subscription services that can help you accomplish this. I’ve been using Portfolio123 for years to rank my holdings, and as a result I no longer agonize over what stocks to sell. I have my own subscription service that will rank stocks for you.
But you can do this with pencil and paper if you’d like, or talk it out with fellow investors. Just disregard price movements.
Sometimes I sell stocks that have gone way up, sometimes I sell stocks that have gone way down, and sometimes I sell stocks that haven’t moved much at all. But I don’t look at what they’ve done price-wise: I look at how likely they are to do well down the road. And after I sell them, I don’t look to see how they’re performing, and I don’t try to second-guess my choice. Saying goodbye to an old holding now gives me just as much pleasure as saying hello to a new investment. After all, if the fundamentals are good, I may buy that old holding back one of these days.