Analysis in selling could be just as important as buying
In the world of investing, there is significant attention spent on which stocks to buy and add to a portfolio – fundamental company and industry research, techniques to determine intrinsic value and financial analysis are just three potential areas of focus for a prospective investment. Rarely however, do you see much attention devoted to the other critical part of the equation – when to sell.
While the intuitive explanation is that these strategies advocate a buy and hold approach, individual stocks don’t always deliver positive compounding returns – if they did, you would rarely – if ever –sell your stock (unless you needed the capital for another opportunity).
A recent empirical paper titled “Selling Fast and Buying Slow: Heuristics and Trading Performance of Institutional Investors” by Akepanidataworn, Di Mascio, Imas and Schmidt highlighted this discrepancy:
- Investors displayed clear skill in buying – positions added to the portfolio outperformed both the benchmark and a strategy which randomly bought more shares of assets already held in the portfolio.
- Selling decisions failed to beat a no-skill strategy of selling randomly chosen positions – the level of underperformance was observed to be significant, such that it dragged down performance by 50 to 100 basis points.
- Selling decisions coinciding with releases of portfolio-relevant information outperform – for example, following the release of company earnings announcements.
So why the discrepancy in buying and selling? While buying decisions are forward looking, the study suggests investors tend to place too much importance on past returns when deciding to sell; in fact, assets with extreme returns (whatever has gone up a lot or down a lot) were more than 50 per cent likely to be sold than those in the middle of the pack. The paper however found no such bias when evaluating buying decisions.
As demonstrated by point iii), investors incorporating information to predict the future returns of an asset when determining whether to buy AND sell should improve the overall investment performance of a portfolio.
A simple technique that may help with the selling decision is to ask yourself the question: “Would you be willing to invest at the current price?”
This helps to frame the selling decision as a forward-looking issue, as opposed to relying on heuristics that are often backward looking in nature.