Sold out early? On the one that got away

Compared with selling, buying stocks is straightforward. We find stocks that look cheap on a fundamental basis, buy them with a margin of safety, and hold until such time as we’re proven right or wrong.

If you’re no good at it, the market will find you out soon enough. And on those occasions where things don’t go to plan, it’s often easy in hindsight to identify why. Selling, though, is an altogether different game, as a few personal and painful examples ably demonstrate.

After making a 30% profit in three months, in mid-2003 I sold my shares in Ausdrill. Then the resource boom really took off and the stock went up five-fold. Later that same year, I cashed out of Data#3 for a 30% return in four months. The stock has subsequently risen 10-fold, outperforming every other stock I held at the time or bought subsequently.

My investing history is littered with sells that went on to generate perfectly decent, even outstanding, returns. So I’m a failure right? I don’t see it that way. It could be a source of regret but it’s not. If you feel badly about ‘lost’ returns from early sells, perhaps my ponderings will make you feel better about it and keep you focussed on the main game, which isn’t selling near the top.

Fundamental aim

My principal investment objective is to maintain, at all times, a portfolio of underpriced stocks. That gives me the best possible overall shot at outperforming the market, without taking large risks. As long as I achieve that aim, hindsight-biased thinking over what might have been offers little useful insight and may in fact cause harm.

Here’s why: When a value investor buys a stock, they’re doing so with a perceived, and hopefully genuine, edge. They’re looking for the metaphorical loaded dice, and preferably in a game being played against dumb competition. By refusing to play anything other than a lopsided bet, they’ll end up being right more often than wrong and should do well.

But, having made an intelligent purchase decision, what about the intelligent time to sell?

It’s a personal decision, depending on the quality of the stocks in your portfolio – higher quality businesses deserve much more leeway. But this is how I do it: I tend to start selling part of a large position when a stock moves from ‘very cheap’ to ‘mildly cheap’ (compared with my assessment of intrinsic value), selling more again when it trades around ‘fair value’ and completely selling out before it hits ‘overpriced’ or ‘extremely overpriced’.

That’s my rational response to the profitable erosion of my cherished margin of safety. Once a stock price moves above that point, I’m taking on more risk the higher the share price rises above it. So while I aim to purchase outright bargains, I generally don’t wait until a stock is an outright rip-off before selling.

The effect is that I expect less predictable outcomes from my sells than my buys. When I buy, I do so because I believe the deck is firmly stacked in my favour. But when selling, what happens next is more of a crapshoot. I don’t expect my sells to subsequently underperform with any sort of predictability.

Charts 1 and 2 make the point visually (mathematicians, please be gentle – I’ve opted for a normal distribution shifted to the right, but understand that the distribution may indeed become non-normal). In short, the charts show that when you buy a cheap stock, good things are more than likely to happen, but when you sell a fair value one, what happens next is more of a 50:50 bet.

Invert, always invert

The alternative approach to selling stocks once they trade around or a little over fair value would be to hold onto all past purchases unless they become significantly overpriced. Then we’d have a stacked deck in our individual sell decisions and would experience sellers’ remorse far less frequently.

But a consequence of that approach would be a portfolio populated with many mildly or even quite overpriced shares. If that were my portfolio, I’d consider that a major failure. Instead of a collection of underpriced stocks that minimise unnecessary risk, on average I’d own a less-cheap portfolio. Yes, I’d make fewer ‘mistakes’ on my sells, but far more on my holds. My overall portfolio returns would almost certainly suffer as a result.

Of course, selling a ten-bagger when it’s only just doubled causes some regret; I’m human like everyone else, not a cold, forward-looking odds-maker all the time.

But it makes a great deal of sense to recognise that, even when they execute perfectly, value investors are likely to feel far more satisfied with their history of purchases than their history of sales. And, perhaps paradoxically, the better we become at value investing, the wider the gulf in efficacy between our buys and sells is likely to become.

As ever, though, there’s a trap. In attempting to make fewer sell ‘mistakes’, we open ourselves up to making more hold errors. And in attempting to avoid the regret that comes from selling an individual stock that continues to rise, we risk mismanaging our overall portfolio by favouring the fairly valued stocks we already own over the bargains we don’t yet own.

Any approach that would have seen me holding onto Ausdrill and Data#3 in 2003 would likely have seen me hold on to quite a few dogs, too. I would also have ended up with less invested in some of the big winners I did end up owning.

Yes, selling out of a stock that continues rising is intensely annoying but it’s a mistake to label it an error. Instead, I like to view them as a wise refusal to play when I’m not confident that the odds remain firmly in my favour.

Ultimately, it’s the stocks we own that dictate our investment returns, not the ones we don’t. Making sure that the stocks that currently sit in your portfolio are always the most intelligent bets you can find is what will determine your future financial wellbeing.

By all means, when you sell too soon try to learn from past mistakes. But be aware of hindsight bias and its ability to shift your focus away from what counts. In a fishing contest, the winner is whoever catches the most fish, not whoever lets the fewest fish get away. Investing is the same. Filling your boat with fish is what counts, not whether a few big ones got away in the process.