Seth Klarman describes selling as “the hardest decision of all.” That would make buying the second hardest decision.
The art of buying means first realizing that price fluctuations are a feature of markets that also tend to trigger emotions like fear and greed. If an investment is really worth buying, day to day price moves shouldn’t matter.
But once something is bought, those emotional triggers still exist, only now your money is at stake, along with a new issue of knowing precisely when to sell. Here’s Klarman:
Many investors are able to spot a bargain but have a harder time knowing when to sell. One reason is the difficulty of knowing precisely what an investment is worth. An investor buys with a range of value in mind at a price that provides a considerable margin of safety. As the market price appreciates, however, that safety margin decreases; the potential return diminishes and the downside risk increases. Not knowing the exact value of the investment, it is understandable that an investor cannot be as confident in the sell decision as he or she was in the purchase decision.
To deal with the difficulty of knowing when to sell, some investors create rules for selling based on specific price-to-book value or price-to-earnings multiples. Others have rules based on percentage gain thresholds; once they have made X percent, they sell. Still others set sale price targets at the time of purchase, as if nothing that took place in the interim could influence the decision to sell. None of these rules makes good sense. Indeed, there is only one valid rule for selling: all investments are for sale at the right price.
Decisions to sell, like decisions to buy, must be based upon underlying business value. Exactly when to sell – or buy – depends on the alternative opportunities that are available. Should you hold for partial or complete value realization, for example? It would be foolish to hold out for an extra fraction of a point of gain in a stock selling just below underlying value when the market offers many bargains. By contrast, you would not want to sell a stock at a gain (and pay taxes on it) if it were still significantly undervalued and if there were no better bargains available…
If selling still seems difficult for investors who follow a value-investment philosophy, I offer the following rhetorical questions: If you haven’t bought based upon underlying value, how do you decide when to sell? If you are speculating in securities trading above underlying value, when do you take a profit or cut your losses? Do you have any guide other than “how they are acting,” which is really no guide at all?
You’ll notice that none of the reasons to sell revolve around your feelings. Nor is it because the price moved or the market moved or because of big financial headlines or who just got elected or what the Fed did or what you’re crazy uncle said over the holidays about something in your portfolio.
No, the reason to sell should be based on value. If you bought it because it was cheap, you should sell because it’s no longer cheap. If you bought for other reasons, then the reason to sell is harder to pin down, making it easier to sell for stupid reasons like price moves, big headlines, what your crazy uncle said, or any other excuse you come up with at the time.
Of course, valuation sometimes falls in a highly subjective range. Things like the nagging endowment effect bias our value of the things we own. My stocks are obviously worth more because I own them, right? Of course not, yet some investors subconsciously add a premium to things they own.
And what about fund investors? Nobody is valuing all 500 stocks in the S&P 500 to see if their index fund is cheap or not. Instead, they might use a proxy like P/E or P/E 10 (CAPE), which has its own limitations, especially in the short term.
Despite Klarman’s objections, simple rules are the best option, if unbiased valuation isn’t your strong suit. Rules beat having no reason and excuses, certainly. Rules also provide consistency at times when it’s needed most by making an unemotional decision — for action or, more importantly, inaction — in a system that frequently overwhelms emotion.
And the use of rules have some big-name supporters too. Ben Graham outlined the use of rules in 1976:
What’s needed is, first, a definite rule for purchasing which indicates a priori that you’re acquiring stocks for less than they’re worth. Second, you have to operate with a large enough number of stocks to make the approach effective. And finally you need a very definite guideline for selling.
Following the quote, Graham recommended a sell rule of either after 2 to 3 years or a 50% gain, whichever came first.
Joel Greenblatt followed Graham’s lead, using a slightly different sell rule in his Magic Formula strategy in The Little Book that Beats the Market. The rule: If after one year, the stock is still cheap — based on his criteria — then hold onto it, otherwise, sell.
Greenblatt’s rule worked well enough that Grey and Carlisle borrowed it for their strategy in Quantitative Value, Carlisle did it again in Deep Value and The Acquirer’s Multiple, Crosby used it in The Laws of Wealth…that’s just a start…and it’s not limited to value strategies. Trend, tactical, and buy-and-hold strategies are all built on simple rules.
So Klarman is right. Your reason to sell should be grounded in common sense — valuation being the most common sense reason there is. Absent common sense or valuation skills, sell rules, along with buy rules, run a close second for filling that void (though, it’s an easy argument that rules are more consistent decision-makers than all but the most unbiased investors).
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- To Index Bonds or Not? – J. Rekenthaler
- A Tale of Two Systems: 19th Century Behavioral Insights From Poe, Austen, and Dickens – Behavioral Scientist
- Why Smart People are Vulnerable to Putting Tribe Before Truth – Scientific American
- On Writing Better: Becoming a Writer – J. Zweig
- 52 Things I Learned in 2018 – Flux