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The art of selling

Investors are too quick to sell winning stocks and too slow to sell losers. We can mitigate this problem by taking ego out of investing.
July 28, 2021
  • Investors cut their winners to soon and hold onto losing stocks too long. This puts them on the wrong side of momentum effects.
  • We do this because we let our ego intrude into the investment process. We should instead use strict rules for selling. 

There’s more to good investing than buying the right stocks. We must also sell the right ones. And this is a job which many investors have for years done badly.

Recent research by Warwick Business School’s Neil Stewart and colleagues has shown this. They found that clients of Barclays Stockbrokers are much more likely to sell shares if they are above their buying price than if they are below it – and even more likely to sell if the price is above the previous peak since they bought. Investors cut their winners and run their losers.

This is not a new finding. Back in 1985 Hersh Shefrin and Meir Statman showed the same thing was true of US investors. They called this the disposition effect.

Since then, economists have found that investors do this around the world. And not just in equities. Andrew Brown and Fuyu Yang at the University of East Anglia have found that Betfair clients are quicker to cash out on profitable bets than unprofitable ones. And Stewart and colleagues also found that home-owners are much more likely to sell if their house has risen in price since they bought it than if it hasn’t.

Cutting our winners and running our losers can be an expensive mistake. My chart shows why. It shows the performance of my portfolios of past winners and losers – the 20 stocks to have risen and fallen the most in the previous 12 months. Past winners have beaten the market enormously in the past 10 years, which means selling winners has meant missing out on further profits. Past losers, by contrast, have under-performed even including last autumn’s massive bounce. Holding onto losing stocks, therefore, has led to further losses.

Which poses the question: why do so many people do this? Alex Imas at Carnegie Mellon University points to part of the answer – that we treat realised losses completely differently from paper ones. After a purely paper loss people tend to gamble in the hope of getting even – which is the equivalent of holding onto losing stocks or even buying more. After a realized loss, however, they avoid risk.

He demonstrated this by getting people to bet on the roll of a die. Those subjects who were randomly forced to cash in their profits and losses after a few rolls went on to bet less if they had lost and more if they had won. But those allowed to run their profits or losses bet more if they had lost. Recent research by Steffen Meyer at the University of Southern Denmark and Michaela Pagel at Columbia Business School has corroborated this. They looked at investors who were forced to realise gains or losses by some unit trusts closing down. They found that investors forced to realise a profit reinvested 80 per cent of the money they got back while those who realised a loss reinvested only half as much.

From the point of view of orthodox economics, these differences make no sense. A paper loss reduces our wealth by exactly as much as a realised loss. So why treat them completely differently?

It’s because our total wealth isn’t the only thing that matters. Instead, says Yale University’s Nicholas Barberis, we evaluate our investments as separate episodes. When we sell a stock at a profit, we put a happy ending to that particular story, and when we sell we put a sad ending onto it. Childish as it seems, this explains why we run our losers. As long as we haven’t sold, the story hasn’t finished and so we can persuade ourselves there is still the chance of a happy ending.

In fact, such persuasion is all too easy. In experiments at Oxford University, Guy Mayraz randomly assigned some people to be farmers who would profit from a rising price of wheat and some to be bakers who would lose from it. He then showed them charts of the wheat price and invited them to extrapolate the future price – and found that farmers forecast higher prices than bakers. Which shows just how easy wishful thinking is.

But why do we think in terms of discrete episodes at all?

It’s because of ego-involvement. Professor Statman says that selling at a profit invokes feelings of pride whereas doing so at a loss entails regret – and perhaps even shame at the realisation that we are not as clever as we thought we were.  Our urge to feel pride and avoid shame makes us quick to realise profits and slow to realise losses. It’s no accident, therefore, that conscientious people are especially prone to the disposition effect as they take more pride in their work than others, and feel worse if they do a bad job.

Pandering to our ego, however, costs us money because it puts us on the wrong side of momentum.

We need, therefore, to take ego out of the process. One way to do this is to remember that even the very best investors lose money on some trades – though they keep quiet about it. In a complex world, nobody can have anything near perfect foresight. The pass mark for a good investor is nearer to 50 per cent than 100 per cent. Another thing to do is to keep judgment out of the selling process by obeying strict rules through having some kind of stop-loss in mind: selling when prices fall below their 200-day average is one good rule, but there are others.

Your shares don’t care about your feelings. And nor should you.