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Friday, April 21, 2017

the conundrum of sell

Investors often consider that decision to buy a stock is the most difficult one. It is; when price and value gaps are to be analyzed. Yet, the decision to sell a stock becomes, probably, more difficult when dealing with human behavior. Investors sell (or don't sell) a stock due to various reasons, some right and some wrong. Let's cut to the chase, and come to the point. There are only four times when a long investor should sell a stock. 

The first is obvious: When you realize that you made a mistake in assessing value of the business; wrong earning power estimation or wrong growth rates. This is assuming the mistake is on over valuation. The quality of the business, after all, was not good enough compared to the price you paid. The second is a followup on the first one, and is more obvious: While your initial buy decision was correct because you found a reasonable gap between price and value, due factors not within your control, the quality of the business deteriorated over a period of time. This could happen because of poor management decisions on operations and/or capital allocation, or because of macro factors. For whatever reasons, the initial assessments of cash flows and growth rates are no longer acceptable. During both occasions, one would be at one's own peril if thumb-sucking is preferred to action.

There are at least two reasons for not selling here; this is when investors are not able to see the obvious: The first is when you don't realize the change in circumstances; i.e. you fail to assess the quality of the business compared to the price paid. The second happens when you are in excessive losses and therefore, hold on to your bias that things will improve; or even when you are in excessive profits and therefore, hold on to your bias that everything is alright. These are the real thumb-sucking situations. That is why behavior is of utmost importance in investing.

The fact is that whether you are in losses or profits is irrelevant. If market conditions are good, you would be lucky to get out of the stock at the first opportunity in profits. If you aren't lucky to see market optimism, it is also rational to sell the stock despite losses. In investing, we cannot leave entirely to the luck factor. A fair amount of analysis and thinking is required. The decision to sell is not easy mainly due to psychological factors.

The third time you should say time to sell is when you find a better investment opportunity. After all, investing is based on picking the best out of one's opportunity costs. If the stock that you bought has the potential to give you a return of say, 15%, and you find yet another stock, bond, or any other investment opportunity that has an expected return of say, 25%, it makes sense to sell one to make way for the other. The damage from inaction, though, is less here compared to the two reasons to sell noted earlier. The quality of the business has not deteriorated, its value has not changed significantly, and a relatively lower expected returns isn't troublesome. We need not be part of every investment opportunity.

The final time you should sell stocks is when there is emergency. Although you cannot invest short term cash in equities, sometimes one finds oneself in a situation where long term funds are to be liquidated for short term needs. These will be extraordinary times, and are therefore only rare.

There may be one more occasion when the investor may decide to sell. That is when you see that the gap between price and value has reduced significantly. Selling the stock is wiser especially when the business is not a high quality one having long term competitive advantages. Stocks of less than high quality businesses can be bought and sold more frequently purely based on price and value gaps. However, it is much wiser to hold on to the high quality businesses if the investor really wants to reap benefits of long term compounding. Wealth creation is always more imminent in a buy and hold strategy than in frequent trades. 

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