Circle of Competence don’t means that you have to know everything about a company and you will do fine for me – you also have to know yourself – how will you react under pressure, under seductions? As Ben Graham have written, you can find the biggest danger for your portfolio in the mirror.
One of the hardest tasks in investing is finding out how to act right when selling a stock. With this article I will look at the difficulties and forces that come into play when I’m thinking of how to sell a stock. I hope this will make me better in that area.
Beeing aware of some psychological pitfalls
If people commit, orally or in writing, to an idea or goal, they are more likely to honor that commitment because of establishing that idea or goal as being congruent with their self-image. Robert Cialdini on Wikipedia
Seeing oneself as a value-investor and buying a stock is a perfect commitment according to Cialdini. Buying a stock is linked with:
- creating a self-image (I am a value investor who is practising buy-and-hold)
- effort (you research, you push the buy-button, you pay the money)
- a decision
- (maybe) making your decision public (blog, friends, your broker)
Once a commitment has been made, the psychological program that is called “I made that decision-I will stand to it” starts working. You can imagine easily how this affects the selling of an already owned stock.
The Confirmation bias is one of the biggest thinking errors. It’s the psychological program that filters new information’s and compares them with our one viewpoints and ideologies. We tend to search information’s that reinforce our own believes.
Confirmation bias is the tendency to search for, interpret, favor, and recall information in a way that confirms one’s preexisting beliefs or hypotheses, while giving disproportionately less consideration to alternative possibilities. Confirmation bias (Wikipedia)
So once you decided that a company is a good company and a good investment, your brain will search for confirmations of this thesis everywhere.
With intelligent algorithms that “scan” your interests and present you matching content – content that you probably will find appealing – this bias got stronger in the past.
… because you don’t want to admit that the loss has gone from a computer screen to real money, you hold on in hopes that you will, one day, make it back to even.
“The most important thing to do if you find yourself in a hole is to stop digging.” – Warren Buffett
They found that the amount participants required as compensation for the mug once their ownership of the mug had been established (“willingness to accept”) was approximately twice as high as the amount they were willing to pay to acquire the mug (“willingness to pay”).
Difficulty of avoiding
Various studies have shown that anchoring is very difficult to avoid. For example, in one study students were given anchors that were obviously wrong. They were asked whether Mahatma Gandhi died before or after age 9, or before or after age 140. Clearly neither of these anchors can be correct, but the two groups still guessed significantly differently (average age of 50 vs. average age of 67).
Some solutions/shortcuts to avoid this psychological pitfalls
The Warren Buffett Solution
“Our favorite holding period is forever” – Warren Buffett
This is probably the most radical way to avoid a wrong sales: Don’t sell! Warren tries to focus on businesses that are so good that he never will have to sell them. If you never sell, you will never make a mistake in selling 😉
Of course there is a chance for a big Mistake of Omission (aka sucking thumb)
And as always, Warren Buffett don’t always follows his own rules. He and his stock-pickers (Todd/Ted) often** sell stocks (DE, WMT, T,) – but the big central positions of the BRK-Stock-Portfolio (WFC, KO, IBM, AXP) essentially stays the same. “When the facts change, I change my mind. What do you do, sir?” – John Maynard Keynes
This solution is not perfect, but focusing on good businesses that you can hold virtually forever may limits the activities that will take place – and therefore lowers the possibility of a dumb action. I think it’s a good way to eliminate mistakes.
**Some fewer known Berkshire-Holdings that were sold out; Data by Gurufocus (link)
2014 Express Scripts
03/2013 General Dynamics
09/2012 CVS Health
09/2012 Dollar General
09/2010 Home Depot
The Ben Graham Solution (kind of)
As I remember Graham used some kind of expiration date on his basket approach. Buy a basket of undervalued (lower than book-value) stocks and wait for them to reach their fair value. Sell them when they reached their calculated fair value or after two years. Two years should be enough for Mr. Market to recognize the fair value of a stock.
Of course Ben Graham was working in a different time. He could collect up the shards of the Great Depression in a big quantity. Deep value today don’t allows a portfolio of 30 promising positions.
By putting a “for Sale” sticker on them in mind it is harder to fall in love with his own stocks (Endowment Bias). I know this Idea aims in the opposite direction of what I called “The Warren Buffett Solution“.
I hope thoughts like that while buying a new stock can help making better decisions afterwards: “Because of the good growth opportunities in the near future and the slight undervaluation compared to the peer group I’m planning to hold the stock for the next 5 years.”
The Eat-dessert-first method?
I like searching for new investment opportunities and expanding my horizons by analysing new companies that I don’t know. It is fun. Way more fun than looking at my holdings and analyse if something went wrong with them which the market hasn’t already discovered. I know I should do more of that work.
By putting the buy of a new stock before the sell of an already owned – I hope I can eliminate the endowment bias. Also it would force myself to do the “unloved” task of choosing a candidate to sell from my portfolio.
I am not sure how I will act in the future and if this article will help me with that task. Of course I will (again) make mistakes in selling stocks, but I hope by making the task more structured I will eliminate some risks/errors. In conclusion this is my plan of how I will act in the future:
- doing more research on my already owned stocks
- establish a “do not touch“- basket of stocks (like WB)
- establish a “maybe for sale”-basket of stocks
- doing research on new companies
- when the research of a new company leads to a buy (maybe) I have to sell other stocks from the “for sale” basket to avoid a cash quote decline or a to big sector-concentration
- when buying a stock I will write down the reason I have bought it and how long I’m planning to hold it
- I will track my decisions (with a wish-list app) to make sure that my sold stocks don’t outperform my holdings