Should investors sell stocks just because it's up or down?
This memo is the latest one written by Howard Marks who is an American investor and writer. Marks is the co-founder and co-chairman of Oaktree Captial Management. This memo is of great value for all investors. The second section is as follows:
Selling Because It’s Up
“Profit-taking” is the intelligent-sounding term in our business for selling things that have appreciated. To understand why people engage in it, you need insight into human behavior, because a lot of investors’ selling is motivated by psychology.
In short, a good deal of selling takes place because people like the fact that their assets show gains, and they’re afraid the profits will go away. Most people invest a lot of time and effort trying to avoid unpleasant feelings like regret and embarrassment.
What could cause an investor more self-recrimination than watching a big gain evaporate? And what about the professional investor who reports a big winner to clients one quarter and then has to explain why the holding is at or below cost the next? It’s only human to want to realize profits to avoid these outcomes.
What could cause an investor more self-recrimination than watching a big gain evaporate? And what about the professional investor who reports a big winner to clients one quarter and then has to explain why the holding is at or below cost the next? It’s only human to want to realize profits to avoid these outcomes.
If you sell an appreciated asset, that puts the gain “in the books,” and it can never be reversed. Thus, some people consider selling winners extremely desirable – they love realized gains. In fact, at a meeting of a non-profit’s investment committee, a member suggested that they should be leery of increasing endowment spending in response to gains because those gains were unrealized.
I was quick to point out that it’s usually a mistake to view realized gains as less transient than unrealized ones (assuming there’s no reason to doubt the veracity of the unrealized carrying values). Yes, the former have been made concrete.
However, sales proceeds are generally reinvested, meaning the profits – and the principal – are put back at risk. One might argue that appreciated securities are more vulnerable to declines than new investments in assets currently deemed to be attractively priced, but that’s far from a certainty.
I was quick to point out that it’s usually a mistake to view realized gains as less transient than unrealized ones (assuming there’s no reason to doubt the veracity of the unrealized carrying values). Yes, the former have been made concrete.
However, sales proceeds are generally reinvested, meaning the profits – and the principal – are put back at risk. One might argue that appreciated securities are more vulnerable to declines than new investments in assets currently deemed to be attractively priced, but that’s far from a certainty.
I’m not saying investors shouldn’t sell appreciated assets and realize profits. But it certainly doesn’t make sense to sell things just because they’re up.
Selling Because It’s Down
As wrong as it is to sell appreciated assets solely to crystalize gains, it’s even worse to sell them just because they’re down. Nevertheless, I’m sure many people do it.
While the rule is “buy low, sell high,” clearly many people become more motivated to sell assets the more they decline. In fact, just as continued buying of appreciated assets can eventually turn a bull market into a bubble, widespread selling of things that are down has the potential to turn market declines into crashes. Bubbles and crashes do occur, proving that investors contribute to excesses in both directions.
In a movie that plays in my head, the typical investor buys something at $100. If it goes to $120, he says, “I think I’m onto something – I should add,” and if it reaches $150, he says, “Now I’m highly confident – I’m going to double up.”
On the other hand, if it falls to $90, he says, “I’m going to think about increasing my position to reduce my average cost,” but at $75, he concludes he should reconfirm his thesis before averaging down further. At $50, he says, “I’d better wait for the dust to settle before buying more.” And at $20 he says, “It feels like it’s going to zero; get me out!”
On the other hand, if it falls to $90, he says, “I’m going to think about increasing my position to reduce my average cost,” but at $75, he concludes he should reconfirm his thesis before averaging down further. At $50, he says, “I’d better wait for the dust to settle before buying more.” And at $20 he says, “It feels like it’s going to zero; get me out!”
Just like those who are afraid of surrendering gains, many investors worry about letting losses compound. They might fear their clients will say (or they’ll say to themselves), “What kind of a lame-brain continues to hold a security after it’s gone from $100 to $50? Everyone knows a decline like that can foreshadow further declines. And look – it happened.”
Do investors really make behavioral errors such as those I’ve described? There’s plenty of anecdotal evidence. For example, studies have shown that the average mutual fund investor performs worse than the average mutual fund.
How can that be? If she merely held her positions, or if her errors were unsystematic, the average fund investor would, by definition, fare the same as the average fund. For the studies’ findings to occur, investors have to on balance reduce the amount of capital they have in funds that subsequently do better and increase their allocation to funds that go on to do worse.
Let me put that another way: on average, mutual fund investors tend to sell the funds with the worst recent performance (missing out on their potential recoveries) in order to chase the funds that have done the best (and thus likely participate in their return to earth).
How can that be? If she merely held her positions, or if her errors were unsystematic, the average fund investor would, by definition, fare the same as the average fund. For the studies’ findings to occur, investors have to on balance reduce the amount of capital they have in funds that subsequently do better and increase their allocation to funds that go on to do worse.
Let me put that another way: on average, mutual fund investors tend to sell the funds with the worst recent performance (missing out on their potential recoveries) in order to chase the funds that have done the best (and thus likely participate in their return to earth).
We know that “retail investors” tend to be trend-followers, as described above, and their long-term performance often suffers as a result. What about the pros? Here the evidence is even clearer: the powerful shift in recent decades toward indexing and other forms of passive investing has taken place for the simple reason that active investment decisions are so often wrong.
Of course, many forms of error contribute to this reality. Whatever the reason, however, we have to conclude that, on average, active professional investors held more of the things that did less well and less of the things that outperformed, and/or that they bought too much at elevated prices and sold too much at depressed prices. Passive investing hasn’t grown to cover the majority of U.S. equity mutual fund capital because passive results have been so good; I think it’s because active management has been so bad.
Of course, many forms of error contribute to this reality. Whatever the reason, however, we have to conclude that, on average, active professional investors held more of the things that did less well and less of the things that outperformed, and/or that they bought too much at elevated prices and sold too much at depressed prices. Passive investing hasn’t grown to cover the majority of U.S. equity mutual fund capital because passive results have been so good; I think it’s because active management has been so bad.
Back when I worked at First National City Bank 50 years ago, prospective clients used to ask, “What kind of return do you think you can make in an equity portfolio?” The standard answer was 12%. Why? “Well,” we said (so simplistically), “the stock market returns about 10% a year. A little effort should enable us to improve on that by at least 20%.” Of course, as time has shown, there’s no truth in that. “A little effort” didn’t add anything. In fact, in most cases, active investing detracted: most equity funds failed to keep up with the indices, especially after fees.
What about the ultimate proof? The essential ingredient in Oaktree’s investments in distressed debt – bargain purchases – has emanated from the great opportunities sellers gave us. Negativity reaches a crescendo during economic and market crises, causing many investors to become depressed or fearful and sell in panic. Results like those we target in distressed debt can only be achieved when holders sell to us at irrationally low prices.
Superior investing consists largely of taking advantage of mistakes made by others. Clearly, selling things because they’re down is a mistake that can give the buyers great opportunities.
To be continued...
To be continued...
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ProfitTogether : Interesting to read but have to wait until the whole write up is complete before making a conclusion.
Good read.
71068725 : A lot of beginner investors don’t understand the market don't know how to read charts, or index and All that comes with stocks so they tend to make the mistake of selling low or buying high
DipKing :
Spearhead : Good
squarema : This article uncovers the behavior of most retail investors including me. I used to sell just because the price of stocks dropped more than I can withstand. Yes, the psychology theory is correct. when the stock dropped too low, one can start to lose confidence and sell immediately to prevent further loss. The panicky feeling is all too familiar, just like getting on a bungee ride. So, is investing a game to you? Are you chasing for that adrenaline rush?
Pius Wawire : This is good
DamVaz1 : Indeed…and the real money is in the minute trades when their just oscillating within a few percentage points….
101754615 : The writer failed to distinguish between speculative plays in "growth" stocks and investment in big-cap dividend-paying "blue chip" stocks. For the former, it would be irresponsible not to set a stop-loss and profit-taking price targets.
Pochong 101754615 : You will be silly to follow those seemingly "good advice" from gurus and market writers. Do not listen to the mainstream media news, gurus or chatroom alerts. Just open your brokerage charts and trade the chart patterns. Thats all.
Ttt Taylor : lol up
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