Why breaking up is hard to do - part 1

More than a decade has passed since I first purchased a holding in ARB Corporation, a manufacturer and marketer of 4WD accessories. ARB regularly features on lists of Australia's best businesses and, for value investors, is up there with CSL and Flight Centre – added to our Buy List late last year (and our portfolios in February) although since downgraded to Hold – as a supremely well-managed company.

Since then, ARB has been one of my better performers. Purchased at around $3.30, it now trades above $16.50. I'd like to say this was down to good judgement, albeit vicariously (thank you, Gareth Brown). The truth is less complimentary. I got lucky.

Over the years I regularly felt the urge to sell. When the GFC hit, I presumed a decline in non-discretionary expenditures was inevitable. Twelve volt fridge freezers for four wheel drives were surely the epitome of that description. Didn't happen. Nor did the collapse in commodity prices that might have caused a fall in demand for ARB's products targeted at the sector.

Then there was the fact that my investment had first doubled, then tripled, then quadrupled. That old saying about not going broke taking a profit jumped into my head each time. I could say I was wise enough to resist but that's not true either.

The real reason is that life – children, health scares, divorce, all the usual stuff – got in the way and, after six years with Intelligent Investor, I needed a break. That enforced inactivity worked in my favour. The result was an accidental five-bagger.

This two-part article has two objectives. The first is to help you understand why we find it difficult to sell well (part one). Then, having unpicked its complexities, in part two we'll suggest some strategies to help you get better at it.

Why selling is so hard

Buying stocks is easy, or at least it can feel that way. Developing analytical skills is simply a matter of time and application. Most of us can get reasonably good at it and if not, well, there's always Intelligent Investor. Then, once we find an undervalued stock, excitement and over-confidence kick in right before we hit the Buy button.

If approached sensibly, the act of building a portfolio should make us more astute buyers. The selling decision, on the other hand, entails us overcoming more psychological factors than inherent optimism. The problem can be split between rising and falling share prices, and selling too early or too late. Let's deal with selling early first.

Note: in the following headings, the word ‘good' refers not just to the quality of a business but also the degree of discrepancy between its price and intrinsic value. Even with an awful business there's a price where it can make sense to buy.

1. Being too quick to sell a good stock after its price has risen

The above anecdote alludes to this problem. If we believe that we ‘can't go broke taking a profit' it's easy to sell too early, denying us the opportunity of a good stock to compound returns over time. This reveals the human bias towards activity, regardless of its consequences, over inactivity. There's a reason why ‘Just do it' resonates with so many of us.

For many investors, the act of trading itself is a moment of what shrinks call self-actualisation, where the act of buying or selling a stock brings their own ideas about themselves to life. To not trade becomes a denial of self and a day trading account soon follows.

In ARB's case, the rise in its stock price was accompanied by a commensurate increase in intrinsic value. But what about a situation where it isn't, where a stock's price is rising without good reason?

2. Hanging onto a poor stock after its price has risen

This decision is equally complicated but for different reasons. As senior analyst James Greenhalgh says: “If you've made a decent profit, you'll be much more psychologically committed to a stock, finding it harder to sell.”

This is part endowment effect – where people ascribe more value to things merely because they own them – and part fear of missing out (FOMO). Graham Witcomb's excellent post (Do we fall in love with our investments? Hint: Yes] offers more detail but here's the money quote:

“In one experiment, people were given either a mug or a pen at random. They were then offered the chance to trade their item for the alternative. Bizarrely, almost no one wanted to trade. Furthermore, when asked how much the mugs and pens were worth, those participants who received mugs thought mugs were twice as valuable compared to those who received pens, and vice versa.”

If the mere act of receiving something creates value, imagine the impact of paying for it and then seeing its price rise?

If that weren't enough, thereafter more behavioural heuristics kick in. Recency bias encourages us to conclude that recent price rises indicate future price rises. And FOMO ensures we hang on to take advantage of them, even though they may not happen.

Then, heaven forbid, if the share price does continue to rise, these effects are compounded by confirmation bias – the tendency to interpret new evidence as confirmation of one's existing beliefs or theories. No wonder selling a stock with a rising share price is hard.

3. Being too quick to sell a good stock after its price has fallen

If anything, for investors facing a tumbling share price it's even worse. First, we are prone to conclude that a share price fall in itself is evidence of a problem (it sometimes is, although only in hindsight is this revealed).

Again, this is loss aversion. We may have lost, say, 30% of our stake but that exacerbates concerns about hanging on to the remaining 70%. Even if further analysis reveals the magnitude of the share price fall is out of proportion to the underlying problem we can be “panicked out”.

4. Hanging onto a poor stock after its price has fallen

Sometimes a share price fall is warranted, and we fail to appreciate the change in circumstances. Research director James Carlisle explains it like this: “Each new piece of information, seemingly inconsequential on its own, is a minor step away from the original premise. And before you know it, the company is miles from where you expected (and hoped) it might be. The endowment effect slows down this realisation and we hang on.”

Whether a stock's price has risen, fallen, or not changed at all, there's a host of psychological tricks that our brains play on us to prevent us from selling well.

In part two we'll unveil a series of techniques your analytical team uses to overcome them. In the meantime, if you'd like to share your own approach to selling, please ‘share it with the group' below.

Note: The Intelligent Investor Growth and Equity Income portfolios own shares in Flight Centre. You can find out about investing directly in Intelligent Investor and InvestSMART portfolios by clicking here.

Disclosure: John Addis is still a shareholder in ARB Corp.