The US stock market has risen in the past 18 months, driven in part by FOMO (fear of missing out) among investors. While investors can be impulsive when buying stocks, it is their sell decisions that really spoil them.
Professional investors show skill when buying stocks, but their sell decisions keep them underperforming standards. That’s the conclusion of a recent working paper, “Selling Fast and Buying Slow”, by four researchers who examined the business of more than 700 professionally managed portfolios.
Because of poor selling decisions, portfolio managers forego 80 basis points of returns each year, on average, when compared to a random selling strategy — or the equivalent of $80 on a $10,000 investment.
Market pros are also people who are prone to some of the same flawed investment decisions as all investors, who tend to “short neglect” to sell, notes Adam Grossman, founder of Mayport Wealth Management, who wrote about the study in another for the Humble Dollar website. This study should serve as a cautionary tale about how difficult it is to trade individual stocks, Money says. “Stick to an index box if you can because it isolates you from your crazy decisions.”
How to avoid common investing mistakes
One lesson from the study is that investors are actually very good at buying stocks that will outperform their criteria, but they don’t devote the same energy to selling.
The study found that rather than focusing on expectations of the stock’s future returns, portfolio managers are exposed to behavioral biases such as how recent the information motivating decision-making, the weight of the stock in the portfolio, past returns or when they are under stress.
“They seem to focus primarily on finding the next great idea to add to their portfolio and view selling largely as a way to raise money for purchases,” the study authors wrote.
To make better selling decisions, Grossman advises a four-step plan: Treat selling with as much deliberation as buying, have a plan with decision rules for selling stocks, think about how each stock fits into your overall portfolio and don’t let the size of the investment cloud your decisions.
Liz Young, SoFi’s head of investment strategy, adds that selling strategy is just as important for retail investors as it is for professionals. Establishing these types of rules to trigger a potential selling decision will also help you keep your emotions in check when the time is right, she says.
“My first tip is to pick a drop and only value the stock when it’s there,” Young says. Here’s how to implement this type of strategy in practice: If you create a 20% limit on losses – the amount that puts a stock in a bear market – you just have to re-evaluate your investment thesis at the time to avoid being too active in your portfolio or responding to short-term factors. “You may decide that it is not the time to sell, and that it is actually a buying opportunity.”
Furthermore, you don’t need to sell all the shares in your holding – or sell at once. Young and Grossman recommend a reverse average cost of sale strategy in which you sell stock regularly, just as you would when buying.
This type of strategy can be beneficial if the stock swells to become a significant weight in your portfolio because selling all at once can be “excessive,” Grossman says.
And if the stock price fluctuates after your selling strategy is activated, “dollar averaging is a good way to protect yourself,” Young adds.
Don’t forget about taxes
Grossman says the impact of capital gains taxes on investment earnings is another important factor to consider in your selling strategy because massive gains per share in your portfolio may not be the best reason to sell. Instead, you should wait for other triggers in your selling strategy to prompt that decision, he advises.
While the most obvious reason to sell a stock is that you need the money, defining a selling strategy up front can help ensure that these decisions don’t reduce your performance — or make you second-guess when new information appears that causes it. Grossman says the stock price is rising again. “Try to look at your portfolio through a lens that brings it some order, and that can tell you when a sale makes sense.”
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