The Surprisingly Simple Reason Even Investors Who Pick Great Stocks Don't Beat the Market
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The U.S. stock market has surged in the past 18 months, fueled in part by FOMO (a fear of missing out) among investors. While investors can be impulsive when buying stocks, it’s their selling decisions that really trip them up.
Professional investors demonstrate skill when buying stocks, but their selling decisions cause them to underperform benchmarks. That’s the conclusion of a recent working paper, “Selling Fast and Buying Slow,” by four researchers who examined the trading activity of more than 700 professionally managed portfolios. Because of bad selling decisions, portfolio managers forgo 80 basis points in returns each year, on average, when compared with a random-selling strategy — or the equivalent of $80 on a $10,000 investment.
The market’s pros are people, too, prone to some of the same flawed investment decisions as all investors, who tend to give “short shrift” to selling, notes Adam Grossman, the founder of Mayport Wealth Management, who wrote about the study in a post for the web site Humble Dollar. This study should serve as a cautionary tale of how challenging it is to trade individual stocks, he tells Money. “Stick with an index fund if you can because it insulates you from your own maddening decisions.”
How to Avoid Common Investing Mistakes
A lesson from the study is that investors are actually pretty good at buying stocks that will outperform their benchmarks, but they just don’t devote the same energy to selling. The study finds that rather than focusing on a stock’s future returns prospects, portfolio managers are prone to behavioral biases like how current the information prompting the decision is, the stock’s weight in the portfolio, past returns or when they’re stressed.
“They appear to focus primarily on finding the next great idea to add to their portfolio and view selling largely as a way to raise cash for purchases,” the study’s authors wrote.
To make better selling decisions, Grossman advises a four-step plan: Treat selling with as much deliberation as buying, have a plan with decision rules for selling stocks, consider how each stock fits into your overall portfolio and don’t let the size of the investment cloud your decisions.
A sell strategy is just as important for retail investors as it is for the professionals, adds Liz Young, head of investment strategy at SoFi. And establishing these types of rules to trigger a possible sell decision will also help you to keep your emotions in-check when the time comes, she says.
“My No. 1 tip is to pick a percentage drop and only evaluate the stock when it’s there,” Young says. Here’s how that type of strategy plays out in practice: If you establish a 20% threshold for losses — the amount that puts a stock into a bear market — then you should only re-evaluate your investment thesis at that time to avoid being too active in your portfolio or reacting to short-term factors. “You may decide that it’s not a time to sell, and that it’s actually a buying opportunity.”
What’s more, you don’t need to sell all of the shares in your holding — or sell at once. Both Young and Grossman recommend a reverse dollar-cost averaging strategy for selling in which you regularly sell shares, just as you may do when buying. This type of strategy can be helpful if a stock has ballooned to become a big weighting in your portfolio because selling all at once might be “extreme,” Grossman says. And in the event that the stock price fluctuates after your sell strategy has been triggered, “dollar-cost averaging is a decent way to protect yourself,” Young adds.
Don't forget about taxes
The impact of capital gains taxes on investment profits is another important factor to consider in your selling strategy because an enormous gain for one stock in your portfolio may not be the best reason to sell, Grossman says. Rather, you should wait for other triggers in your sell strategy to prompt that decision, he advises.
While the most obvious reason to sell a stock is because you need the money, outlining a selling strategy in advance can help ensure those decisions don’t cut into your performance — or cause you to second-guess selling once new information comes out that causes a stock’s price to jump higher again, Grossman says. “Try to look at your portfolio through a lens that brings some order to it, and that can tell you when it makes sense to sell.”
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