When to Sell Stocks

We see plenty of content on buying stocks, picking the next big winner, the next 100-bagger, the next Apple…

But investing is a long game featuring failure just as much as success. Dealing with the former is as important as preparing for the latter.

That’s why sell decisions matter.

Buying a stock isn’t the culmination of the investment process but a transition to a different phase.

When you buy stocks, the question isn’t too far behind — when should you sell?

Selling stocks and investor behaviour

It is a common refrain that investors sell winners too early and losers too late. A horticultural variant gets to the same idea; investors cut the flowers and water the weeds.

But why?

This backward tendency has a name in academic literature — the disposition effect.

Countless studies have shown individual investors are more likely to sell a stock that has gone up than one that has gone down.

But the literature is ambivalent on why. An oft-cited paper in The Journal of Finance writes:

‘While the disposition effect is a fundamental feature of trading, its underlying cause remains unclear. Why do individual investors have a greater propensity to sell stocks trading at a paper gain rather than those trading at a paper loss? In a careful study of the disposition effect, Odean (1998) shows that the most obvious potential explanations — explanations based on informed trading, rebalancing, or transaction costs — fail to capture important features of the data.’

In the absence of clear explanations, behavioural economists suggest the answer lies in our aversion to risk.

According to prospect theory — espoused by Kahneman and Tversky — we are more sensitive to losses than gains.

In a weird twist, we are risk-averse to gains but risk-seeking to losses. As the earlier mentioned paper explains:

‘Prospect theory, a prominent theory of decision-making under risk proposed by Kahneman and Tversky (1979) and extended by Tversky and Kahneman (1992), posits that people evaluate gambles by thinking about gains and losses, not final wealth levels, and that they process these gains and losses using a value function that is concave for gains and convex for losses. The value function is designed to capture the experimental finding that people tend to be risk-averse over moderate-probability gains (they typically prefer a certain $100 to a 50:50 bet to win $0 or $200), but tend to be risk-seeking over moderate-probability losses (they typically prefer a 50:50 bet to lose $0 or $200 to a certain loss of $100).’

That’s very interesting.

Investors sitting on a $1,000 paper loss tend to prefer a 50/50 bet of either breaking even or losing $2,000 over booking a certain loss of $1,000.

This rings true. How many times have you heard people say, ‘I’ve already lost XX% on this stock, I might as well hold in case it turns around’.

But this response contains a subtly different explanation for the disposition effect.

Holding on for mean reversion

Reluctance to realise losses may stem from optimism.

Here’s Terrance Odean writing in The Journal of Finance:

‘Investors might choose to hold their losers and sell their winners not because they are reluctant to realize losses but because they believe that today’s losers will soon outperform today’s winners.

‘If future expected returns for the losers are greater than those for the winners, the investors’ belief would be justified and rational. If, however, future expected returns for losers are not greater than those for winners, but investors continue to believe they are despite persistent evidence to the contrary, this belief would be irrational. In experimental settings, Andreassen (1988) finds that investors buy and sell stocks as if they expect short-term mean reversion.’

Odean then makes a great observation:

‘An investor who will not sell a stock for a loss might convince himself that the stock is likely to bounce back rather than admit his unwillingness to accept a loss.’

I think this is a common struggle.

A 20%, 30%, or 40% drawdown often invites extenuating questions like, ‘But what if this bounces back? It’s down so much already, surely it’s set for a rebound here?’

But is this approach rational?

Let’s take Cettire [ASX:CTT], for example.

Say you bought the stock at its peak in November 2021 and quickly found your position deep underwater.

Cettire fell 91% from its peak to a low in June 2022. Would you have sold…or hung on waiting for mean reversion?

The bounce did come. Cettire is up by more than 600% since June 2022. But if you bought at the November 2021 peak, you are still down 30% today.

This suggests a good question to ask yourself.

If a stock falls significantly and you continue to hold, ask yourself why you haven’t bought more shares.

If you have conviction in the firm, a significant drawdown is also a significant discount; you’re overjoyed rather than despondent.

But if you’re hesitant to buy the dip, question the hesitancy.

Is your conviction or grasp of the stock’s intrinsic value weak? In which case, why hold the stock at all?

Selling on fundamentals

Stock prices oscillate materially in the short term. And you may be indifferent to this yo-yo-ing if you distinguish between price and value.

This line of thinking is best illustrated by investor Brian McNiven in one of his books:

‘Although business performance is likely to be far from fixed or stable, most listed companies have an average price variation in the course of a 12-month period of about 40% to 50% (meaning the difference between the 12-month high and low prices is about 40% to 50% of the low price).

‘One would need to be exceedingly credulous to believe that, on average, the value of a business varies by 40% to 50% every 12 months. When a stock market falls 10% or more overnight, does this mean that the value of all businesses comprising the market declines by an average of 10% while we sleep?’

But this brings us to the question of fundamentals.

Weathering volatility is easier when you have a strong anchor. In this case, the strong anchor of intrinsic value.

The value of a business does not vary nearly as much as the business’s stock price. But that’s only useful if you know what the value is.

Therefore, knowing when to buy — and sell — requires a reasonable estimate of intrinsic value.

By the way, if you want a detailed account of how to calculate intrinsic value, check out the latest episode of What’s Not Priced In.

Questions to ask when considering selling stock

So, if you are considering selling, here are some questions to ask:

• Have the business’ fundamentals deteriorated since your buy decision?
  • What is your estimate of intrinsic value? And has this estimate changed for the worse?
• Did your investment thesis contain any errors or unreasonable assumptions slowly revealing themselves?
• Are there better opportunities out there?
  • Can you put the money to better use elsewhere?

Window of opportunity

Before I go, I wanted to remind you of the recent presentation given by our veteran trader, Murray Dawes.

Murray watches the market with the vigilance of a monk.

And he’s just spotted an opportunity to pick up bargains he thinks don’t come around too often.

He’s dubbed it Window 24.

Murray isn’t a gung-ho punter but a meticulous reader of charts and manager of risk. So when he thinks there are buying opportunities, it’s worthwhile to listen.

You can check out Murray’s ‘Window 24’ presentation here.

Regards,

Kiryll Prakapenka,
Editor, Money Morning