When Should Investors Sell?

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. The memo is of great value for all investors. The third section is as follows:

If you shouldn’t sell things because they’re up, and you shouldn’t sell because they’re down, is it ever right to sell? As I previously mentioned, I described the discussions that took place while Andrew and his family lived with Nancy and me in 2020 in Something of Value.

That experience truly was of great value – an unexpected silver lining to the pandemic. That memo evoked the strongest reaction from readers of any of my memos to date. This response was probably attributable to (a) the content, which mostly related to value investing; (b) the personal insights provided, and especially my confession regarding my need to grow with the times; or (c) the recreated conversation that I included as an appendix. The last of these went like this, in part:

Howard: Hey, I see XYZ is up xx% this year and selling at a p/e ratio of xx. Are you tempted to take some profits?

Andrew: Dad, I’ve told you I’m not a seller. Why would I sell?

H: Well, you might sell some here because (a) you’re up so much; (b) you want to put some of the gain “in the books” to make sure you don’t give it all back; and (c) at that valuation, it might be overvalued and precarious. And, of course, (d) no one ever went broke taking a profit.

A: Yeah, but on the other hand, (a) I’m a long-term investor, and I don’t think of shares as pieces of paper to trade, but as part ownership in a business; (b) the company still has enormous potential; and (c) I can live with a short-term downward fluctuation, the threat of which is part of what creates opportunities in stocks to begin with. Ultimately, it’s only the long term that matters. (There’s a lot of “a-b-c” in our house. I wonder where Andrew got that.)

H: But if it’s potentially overvalued in the short term, shouldn’t you trim your holding and pocket some of the gain? Then if it goes down, (a) you’ve limited your regret and (b) you can buy in lower.

A: If I owned a stake in a private company with enormous potential, strong momentum and great management, I would never sell part of it just because someone offered me a full price. Great compounders are extremely hard to find, so it’s usually a mistake to let them go. Also, I think it’s much more straightforward to predict the long-term outcome for a company than short-term price movements, and it doesn’t make sense to trade off a decision in an area of high conviction for one about which you’re limited to low conviction. . . .

H: Isn’t there any point where you’d begin to sell?

A: In theory there is, but it largely depends on (a) whether the fundamentals are playing out as I hope and (b) how this opportunity compares to the others that are available, taking into account my high level of comfort with this one.

Aphorisms like “no one ever went broke taking a profit” may be relevant to people who invest part-time for themselves, but they should have no place in professional investing. There certainly are good reasons for selling, but they have nothing to do with the fear of making mistakes, experiencing regret and looking bad. Rather, these reasons should be based on the outlook for the investment – not the psyche of the investor – and they have to be identified through hardheaded financial analysis, rigor and discipline.

Stanford University professor Sidney Cottle was the editor of the later versions of Benjamin Graham and David L. Dodd’s Security Analysis, “the bible of value investing,” including the edition I read at Wharton 56 years ago. For that reason, I knew the book as “Graham, Dodd and Cottle.” Sid was a consultant to the investment department at First National City Bank in the 1970s, and I’ve never forgotten his description of investing: “the discipline of relative selection.” In other words, most of the portfolio decisions investors make are relative choices.

It’s patently clear that relative considerations should play an enormous part in any decision to sell existing holdings.

If your investment thesis seems less valid than it did previously and/or the probability that it will prove accurate has declined, selling some or all of the holding is probably appropriate.

Likewise, if another investment comes along that appears to have more promise – to offer a superior risk-adjusted prospective return – it’s reasonable to reduce or eliminate existing holdings to make room for it.

Selling an asset is a decision that must not be considered in isolation. Cottle’s concept of “relative selection” highlights the fact that every sale results in proceeds. What will you do with them? Do you have something in mind that you think might produce a superior return? What might you miss by switching to the new investment? And what will you give up if you continue to hold the asset in your portfolio rather than making the change?

Or perhaps you don’t plan to reinvest the proceeds. In that case, what’s the likelihood that holding the proceeds in cash will make you better off than you would have been if you had held onto the thing you sold? Questions like these relate to the concept of “opportunity cost,” one of the most important ideas in financial decision-making.

Switching gears, what about the idea of selling because you think a temporary dip lies ahead that will affect one of your holdings or the whole market? There are real problems with this approach:

Why sell something you think has a positive long-term future to prepare for a dip you expect to be temporary?

Doing so introduces one more way to be wrong (of which there are so many), since the decline might not occur.

Charlie Munger, vice chairman of Berkshire Hathaway, points out that selling for market-timing purposes actually gives an investor two ways to be wrong: the decline may or may not occur, and if it does, you’ll have to figure out when the time is right to go back in.

Or maybe it’s three ways, because once you sell, you also have to decide what to do with the proceeds while you wait until the dip occurs and the time comes to get back in.

People who avoid declines by selling too often may revel in their brilliance and fail to reinstate their positions at the resulting lows. Thus, even sellers who were right can fail to accomplish anything of lasting value.

Lastly, what if you’re wrong and there is no dip? In that case, you’ll miss out on the ensuing gains and either never get back in or do so at higher prices.

So it’s generally not a good idea to sell for purposes of market timing. There are very few occasions to do so profitably and very few people who possess the skill needed to take advantage of these opportunities.

Before I close on this subject, it’s important to note that decisions to sell aren’t always within an investment manager’s control. Clients can withdraw capital from accounts and funds, necessitating sales, and the limited lifespan of closed-end funds can require managers to liquidate holdings even though they’re not ripe for selling. The choice of what to sell under these conditions can still be based on a manager’s expectations regarding future returns, but deciding not to sell isn’t among the manager’s choices.