Minimizing regret is a loser’s strategy

Investment psychology

Cutting the flowers

Regret is always bad for investors. Strategies for avoiding regret are harmful. Feelings of regret after the fact are always bad. Let’s start with regret avoidance.

Imagine you are holding a good chunk of a stock you bought at $10 per share and it’s now trading at $30. You really like the company and would like to continue holding it. But you are concerned that if the price pulls back below $10 you would hate yourself for not having taken a good profit. At the same time, because you like company, if you sold at $30, you would hate yourself if the stock went on to $100 per share. Let’s call it the problem of ‘the $30 stock’.

This is a classic case of where our emotions can get the better of us. In this post I’ll suggest the wrong way and the right way to deal with this.

The wrong way

The worst thing you can do is come up with an approach that minimizes regret. It would work something like this. You sell half the position and book a profit of $20 per share on that half. You figure that if the stock subsequently drops to $10 per share you will anyway have locked in a gain on half the position. If instead the stock runs up to $100 per share, you will enjoy the gain on the half you kept. Sounds like you can win either way and avoid regret.

The problem with this strategy is that the decision is based solely on emotion, specifically regret avoidance. It has nothing to do with the investment merits of the situation.

Cutting the flowers

The problem of the $30 stock comes up all the time. It’s the flower half of a duo. The other half is about weeds.

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.”

A broader issue

There are two problems. First is seeking to minimize future regrets. Second is having regrets after the fact about the path not taken. They are both pernicious. We make choices in investing as in life. If we make those choices to minimize future regrets, we will be hidebound by conventionality and risk aversion. And if we fret about what might have happened if we’d made different choices it will drive us crazy and also make us risk averse. It’s like the curse of the Monday morning quarterback; always smart after the fact. One of my all-time favorite songs is a French song, famous in the 1950s, titled “Non, je ne regrette rien.” It was sung by Edith Piaf. It means “I don’t regret anything.” You make choices and live with them.

Back to basics

One way to think about the problem of the $30 stock is to reflect on the reasons we might ever want to sell a stock. We all know that Warren Buffett’s favorite holding period is forever as quoted above.  

Several years ago, I wrote a post setting out 19 rules for selling stocks. Let’s go through those rules to see if any apply to the problem of the $30 stock.

At the outset let me make clear that when you are thinking about selling, the price your paid for the stock is irrelevant. Let’s go through the rules:

1. Was the original decision to buy the stock a mistake? It doesn’t look like it with our $30 stock.
2. Has the company lost its way, no longer meeting our rigorous investment criteria? Again, no.
3. Do we need to cash in to invest in a better opportunity that has come along? No.
4. Do we need some cash to live on? Seems not to be the case with our $30 stock. I recently sold part of a holding that was overpriced for this reason.
5. Sell down a position that has become too large. This is not the case described above. My rule of thumb is to sell down any position that grows to 15% of the portfolio.
6. Consider selling when the company makes a big acquisition. It’s often a warning sign of management building an empire. This doesn’t fit with the $30 stock case we are discussing.
7. When the company is subject to a takeover. There is no hard and fast rule here. Very often it’s a good idea to sell even before the takeover closes and take the premium price offered. This is not happening with our case.
8. Consider selling when the company makes a big change in its business model. Not our situation.
9. Consider selling when the balance sheet takes a turn for the worse. Not our situation.
10. Stock price rockets up in short time period. This is a tricky one and may apply to the problem of the $30 stock. But, let’s be clear. Just because the stock price has run up quickly is no reason to sell in and of itself. This applies even if the stock’s price becomes fairly rich. Really wonderful companies will often get overpriced and selling for that reason alone is a mistake because it means selling a position in a first rate company you want to hold for the long haul. It would be a case of cutting the flowers. As an example, I’m currently holding one stock that I figure is about 25% overpriced. The price may come off quite a bit in a general market pullback. I’m not concerned because it’s a great company and I hope to still be holding the position five or ten years from now. I’m not smart enough to try to trade in and out as the price fluctuates.
11. Stocks in the commodity sector need to be treated differently. That’s a different topic and is not applicable to the case we are discussing.
12. A controlling shareholder sells a big chunk of their holdings. This is a warning sign. It may be a prudent diversification by the controlling shareholder and not a concern. It all depends. In any event it doesn’t apply to our $30 stock.
13. Don’t sell just because you want to take a profit. Fisher put it this way: “Willingness to take small losses in some stocks and to let profits grow bigger and bigger in the more promising stocks is a sign of good investment management. Taking small profits in good investment and letting losses grow in bad ones is a sign of abominable investment judgment. A profit should never be taken just for the satisfaction of taking it.” (Fisher, Common Stocks and Uncommon Profits and Other Writings. 1958,1996) p.277. This advice applies to our case.
14. Don’t sell just because the price has moved above intrinsic value or is overpriced. This is really a repeat of what is noted above.
15. Don’t sell because the price earnings ratio has gone up. Price earnings ratios are a poor indicator of the fair value of a stock.
16. Don’t sell because the stock has reached a price target. Buy side analysts offer price targets. They are of little use and may be distracting.
17. Don’t sell in anticipation of a market downturn. This may enter the investor’s mind in thinking about the problem of the $30 stock. Worries about a possible downturn invite the investor to engage in market timing which is a sure-fire way to get poor results.
18. True stock bubbles are a special case. One should move to cash once a true manic stock bubble has been identified. The last time I felt we were in a true generalized stock bubble was in the late 1990’s. Since then, there have been bull and bear markets and lots of foolish behaviour but no true generalized stock bubbles. Since the fall of 2002 I have been 100% in stocks. I do think there will be another generalized stock bubble in the next ten years.
19. Don’t sell because a stock price has gone down. That doesn’t apply to the problem of the $30 stock.

A general rule

There is one overarching rule of portfolio management. Make no sale of a winning stock in your portfolio unless the sale serves to improve the overall quality of the portfolio. Quality includes not only the quality of individual companies but also diversification and balance.

Kahneman refers to a study of trading records of 10,000 brokerage accounts of individual investors spanning a seven-year period. Altogether there were 163,000 trades. The data allowed the researcher, Odean, “to identify all instances in which an investor sold some of his holdings in one stock and soon afterward bought another stock. By these actions the investor revealed that he (most of the investors were men) had a definite idea about the future of the two stocks: he expected the stock that he chose to buy to do better than the stock he chose to sell.” The results: “On average, the shares that individual traders sold did better than those they bought, by a very substantial margin: 3.2 percentage points per year, above and beyond the significant costs of executing the two trades.” (Kahneman, 2011) p.213.

These investors were probably engaged in selling their winners and holding onto their losers and some form of market timing.

Conclusion

The problem of the $30 stock comes up all the time. In some ways selling a stock is a more difficult decision than buying. The main thing is to sell only in accordance with sound investment practice, such at the 19 rules for selling set out above. As I noted in the title to this post, regret minimization in portfolio management is for losers. And regrets after the fact about any decision will warp future judgement.

+++++++++++++++

Here are a few other posts with nuggets of investing wisdom around about selling:

There’s a time to hold ‘em and a time to fold ‘em.

Selling a stock – goodbye old friend

Cut your losses is confused advice

+++++++++++++++

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.

+++++++++++++++

You can reach me by email at rodney@investingmotherlode.com

I’m also on Twitter @rodneylksmith

+++++++++++++++

Check out the Tags Index on the right side of the Home page that goes from ‘accounting goodwill’ to ‘wisdom of crowds’. This will give readers access to a host of useful topics.

+++++++++++++++

You can also use the word search feature on the right-hand side of this page to find references in both blog posts and also in the Motherlode.

+++++++++++++++

There is also a Table of Contents for the whole Motherlode when you click on the Motherlode tab.

Want to dig deeper into the principles behind successful investing?

Click here for the Motherlode – introduction.

If you like this blog, tell your friends about it

And don’t hesitate to provide comments or share on Twitter and Facebook