It is the business that disappoints, not the price
Here is a classic statements of the rule:
Gerald Loeb wrote in one of the best-selling investment books of all time: “Losses must always be ‘cut’. They must be cut quickly, long before they become of any financial consequence.” He adds, “Cutting losses is the one and only rule of the markets that can be taught with the assurance that it is always the correct thing to do.” (Loeb, Gerald M. The Battle for Investment Survival 1935, 2007) p.43.
The problem with this advice is that it mixes up the difference between paper losses and a company becoming a loser. I propose in this post to discuss this difference and get into the psychology that torments investors when a stock is selling at a price less than the investor paid.
Baruch, Fisher, Buffett and Lynch get it right
One of the legendary investors of the 1930s was Bernard Baruch. His rule five reads: “Learn how to take your losses quickly and cleanly. Don’t expect to be right all the time. If you have made a mistake, cut your losses as quickly as possible.” (Pring, Investment Psychology Explained, 1990) p.245. (Baruch, 1957) (Emphasis added)
“More money has probably been lost by investors holding a stock they really did not want until they could ‘at least come out even’ than from any other single reason.” (Fisher, Philip A. (1958,1996). Common Stocks and Uncommon Profits and Other Writings.) p.106 (Emphasis added)
Warren Buffett wrote in the Berkshire Hathaway Chairman’s letter for 1988: “In 1988 we made major purchases of Federal Home Loan Mortgage Pfd. (“Freddie Mac”) and Coca Cola. We expect to hold these securities for a long time. In fact, when we own portions of outstanding businesses with outstanding managements, our favorite holding period is forever. We are just the opposite of those who hurry to sell and book profits when companies perform well but who tenaciously hang on to businesses that disappoint. Peter Lynch aptly likens such behavior to cutting the flowers and watering the weeds.” (Emphasis added)
What Buffett says is that one should not “tenaciously hang onto businesses that disappoint”. It is the business that disappoints, not the price. The price may go down with the normal volatility of the stock market. So long as the company continues to have an outstanding business with outstanding management there is no reason to sell. Selling in such a case would be cutting the flowers.
But, hanging onto a company that has lost its way is like watering the weeds.
Rules for selling
Selling is one of the most difficult tasks in investing. The two primary reasons for selling are: 1) if your original appraisal of the company was mistaken; and 2) if the company loses its way and its prospects change for some reason. Both of these situations come loaded with psychological baggage.
I think this is the main reason selling stocks is so much more difficult than buying. The more you learn about the psychology around selling stocks the better you will be as an investor.
The psychology of holding losers
Barton Biggs was a hugely successful money manager. He wrote: “When you are working with an existing portfolio and reshaping it, there are unrecognized, subconscious, emotional hang-ups that block you from impartial, cold-blooded investment actions like selling. Your baggage is what you already own, and it gets in the way of excellence. There are always positions you believe in, but for one reason or another, the market stupidly has not discovered them yet. It’s hard to make yourself give up on a position, especially since you suspect, as soon as you do, that the ornery, cussed thing will rally. There is a bias against switching, because subconsciously you know you can be wrong twice.” (Biggs, Hedgehogging. 2006) p.131.
Let’s look at these two primary reasons for selling:
- Original decision mistaken
If your original purchase decision was mistaken you should sell. This decision is both the most important and the most difficult to deal with. If the investor has made a mistake in their original appraisal of the investment merits of the company, the mistake must be recognized and acknowledged as soon as possible and action taken. Fisher points out that the proper handling of this situation is largely a matter of ‘emotional self-control. To some degree it also depends upon the investor’s ability to be honest with himself.” (Fisher, 1958,1996) p.105. He adds that ego can come in the way.
Sometimes a rising market can mask a mistake. Sometimes a stock will sit and sulk while the rest of the portfolio prances forward. On an honest review, you acknowledge to yourself the stock never really did meet your rigorous criteria. Once a decision is made to sell a stock for this reason, one should not wait for a general lift in the market to try to squeeze a bit more out of this bad situation. One should sell it right away. Any experience like this should be examined dispassionately to see what lessons can be learned from it. What was it about your original assessment that led to the mistake? What can you learn from it? It may be a valuable lesson.
- Circumstances have changed and the company no longer meets the investor’s rigorous criteria.
Fisher points out that this is why it is important to stay in touch with the affairs of the companies in the investor’s portfolio. Fisher notes that management’s former drive and ingenuity may be replaced by smugness or complacency or inertia. Alternatively, the prospects for increasing markets for the company’s products may dim. The company may no longer be taking active steps to renew the company and its products in a changing world.
When the company you firmly believed in starts to lose its way, your psyche can come under siege.
This of course is bit like the proverbial frog in the pan of water on the hot stove. How hot does it have to be before it will jump?
The basic rule is that once the company starts to lose its way, you should sell immediately. You should not wait for a market uptick claw back a bit of what you have lost.
Back to the psychology of holding losers
Behavioral psychology has studied all this. There is a fear of getting whipsawed and a desire to avoid feelings of regret. Investors worry that if they sell the loser the company will immediately bounce back and the stock will soar and that they won’t be able to get back in. If they sell the stock will they regret it? Regret is a powerful force. They may feel that if they continue to hold the stock their potential for regret will be less.
As Kahneman writes: “people expect to have stronger emotional reactions (including regret) to an outcome that is produced by action than to the same outcome when it is produced by inaction.” He goes on: “The asymmetry in the risk of regret favors conventional and risk averse choices.” (Kahneman, Thinking, Fast and Slow. 2011) p.348-349.
Risk aversion is pathological.
So, holding losers can initially lead to risk averse behavior. But, as the potential loss deepens, holding a loser may lead to risk seeking behavior. The investor may be tempted to double down the loser as a desperate way of recouping a bad situation. Risk seeking is also pathological.
Kahneman notes that: “…finance research has documented a massive preference for selling winners rather than losers – a bias that has been given an opaque label: the disposition effect.” (Emphasis added) He says that the disposition effect is an example of narrow framing. “The investor has set up an account [mental account] for each share that she bought, and she wants to close every account as a gain. A rational agent would have a comprehensive view of the portfolio and sell the stock that is least likely to do well in the future, without considering whether it is a winner or a loser [pricewise].” (Kahneman, 2011) p.344. (Emphasis added)
Humans, with all their foibles and biases, carry out this mental accounting in loser situations. It goes something like this: since the loss hasn’t been taken there is no real loss. Furthermore, there is not yet proof you made a mistake in buying the stock. It might come back. Thus, holding a loser means you don’t have to blame yourself for making a mistake.
As well the investor’s thinking is affected by the sunk cost fallacy. The effort in researching a company, making an investment, reading quarterly and annual reports, monitoring the industry or sector, living with the ups and downs of the business and volatility of the stock gives us a psychological stake in the outcome of the investment. We become attached to the company. There is a risk that we stick with the stock because we have so much of our time and effort invested in the company.
Over time, an investor can develop a loyalty to the stock and the company. Even though the company’s prospects are gradually fading, the loyal investor believes his ‘old friend’ will turn it around and repay his loyalty of many years. The stock becomes endowed with this baggage. It’s called the endowment effect.
As well, the endowment effect causes the price the investor paid to weigh on the investor’s mind. The investor figures they didn’t over pay for the stock. The original purchase price must have been a fair reflection of fair value. The stock becomes endowed with this number. Kahneman has pointed out: “the endowment effect can be eliminated by changing the reference point.” (Kahneman, 2011) p.297. (Emphasis added)
How do we do this? The simple fact is that after you buy a stock the original purchase price is utterly irrelevant. The only thing that matters is the fair value. If the fair value is less than the original purchase price, the fair value is the only relevant reference point. Where the company has lost its way, the fair value reference point will be much less and selling becomes easier.
Stop loss orders
Traders use stop loss orders. I never do. I do not follow any formula. If a stock drops 10% after I have bought it, it is still the same company. I will ask myself why it has dropped. This is when the question arises ‘have I made a mistake?’ One must be prepared to admit that you have. This is when a decision to sell must be made.
Selling stocks is more difficult that buying. One big reason is that selling comes with so much psychological baggage. I think it worthwhile learning all you can about the human foibles around selling. It will make you a better investor.
Readers wishing to dig further into the fine points of selling might take a look at this post:
Other posts on investment psychology
This post is part of a series. Readers are invited to read Investment psychology explainer for Mr. Market – introduction. This will give you a better understanding of some of the terms and ideas and give you links to other posts in the series.
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