FREE NEWSLETTER

The Cardinal Sin

John Lim

THERE’S A LITANY of investment sins. But one may top them all. I’m guessing it’s one you haven’t given much thought to. Until recently, neither did I. The cardinal investment sin: selling your winners too soon.

From 1926 to 2016, more than half of all U.S. stocks—57.4% to be exact—returned less than one-month Treasury bills. In other words, you were better off putting your money into risk-free T-bills than owning these stocks. In fact, more than half of common stocks delivered negative total returns. These stats come from an academic paper by finance professor Hendrik Bessembinder.

Now here’s the real kicker: Bessembinder found that the best-performing shares, a mere 4% of all stocks, were responsible for the stock market’s entire gain over and above T-bills. The remaining 96% of companies collectively generated returns that simply matched one-month T-bills. These findings have profound implications for investors.

If just 4% of stocks—we’ll call them the winners—account for the lion’s share of stock market returns, you had better own them or you’re doomed to underperform the market. If you invest in total market index funds, you will own these winners by default. On the other hand, if you’re picking individual stocks, your odds aren’t great.

But let’s say you’re really smart (or lucky) and happen to pick a fair share of the winners. You face another big hurdle. You must hold on to your winners and not sell them prematurely. Unfortunately, this is easier said than done. Most investors display a strong tendency to sell their winners and ride their losers. This has been termed the disposition effect, first described by behavioral economists Hersh Shefrin and Meir Statman.

The disposition effect can be explained by mental accounting and loss aversion. When an investor buys a stock, a mental account is subconsciously created. The initial investment or cost basis is recorded in this account. If the position is subsequently sold for less than its cost basis, the mental account is closed at a loss. Since losses are painful—particularly to our egos—investors do everything in their power to avoid this from happening, hence the tendency for investors to cling to their losers and even double down on them.

Mental accounting also explains why investors are so quick to sell their winners. Selling a position for a gain closes the mental account in the black. This feels good and strokes the investor’s ego. It also serves as a salve for the pain caused by the losers in the portfolio. Prospect theory says that investors weigh losses more heavily than equal-sized gains. That means the mental anguish from a $1,000 loss must be counterbalanced by gains far in excess of $1,000, thus serving as further impetus for selling winners.

From a tax standpoint, the disposition effect is an anomaly that shouldn’t exist. After all, our tax code rewards us for taking capital losses and penalizes our capital gains. Despite these incentives, the disposition effect is alive and well. It appears that investors are willing to pay a heavy tax to preserve their self-esteem.

Taxes aside, consider the enormous damage done to a portfolio by selling winners too early. As demonstrated in Bessembinder’s paper, strip out the big winners from a portfolio and you are left with middling returns that are on par with T-bills. Why are the winners so vital to a portfolio? Because of the inherent asymmetry between losers and winners.

A losing stock has limited downside. At worst, it can go to zero. In fact, in Bessembinder’s study, a 100% loss was the single most frequent outcome for individual stocks over their lifetime. On the other hand, winners had virtually unlimited upside.

If you talk to seasoned investors, most will confess they struggle far more with the sell decision than the buy one. A recent study of institutional investors confirms this striking discrepancy. While the authors found clear evidence of skill in buying, selling decisions underperformed badly. In fact, they were worse than random selling strategies.

Given the data from Bessembinder’s paper and the behavioral biases plaguing the sell decision, perhaps the best strategy is the one espoused by Warren Buffett: “When we own portions of outstanding businesses with outstanding managements, our favorite holding period is forever. We are just the opposite of those who hurry to sell and book profits when companies perform well but who tenaciously hang on to businesses that disappoint. [Celebrated fund manager] Peter Lynch aptly likens such behavior to cutting the flowers and watering the weeds.”

The greatest investing sin may also explain why active managers find it so hard to beat mindless index funds. Notwithstanding lower fees, cap-weighted index funds have fundamental advantages over their actively managed brethren. As alluded to earlier, a total market index fund by definition will own all the winners. More important, it lets them ride. The manager of an index fund won’t be tempted to sell the winners, nor does he have an ego to preserve.

What’s my advice to active managers and stock pickers? As much as possible, ignore your cost basis and focus on the fundamentals. Remember that the market is right most of the time, so let your losers go and enjoy the tax loss harvest. Most important, fight the urge to cash in on your winners with every fiber of your being.

John Lim is a physician and author of “How to Raise Your Child’s Financial IQ,” which is available as both a free PDF and a Kindle edition. Follow John on Twitter @JohnTLim and check out his earlier articles.

Do you enjoy HumbleDollar? Please support our work with a donation. Want to receive daily email alerts about new articles? Click here. How about getting our twice-weekly newsletter? Sign up now.

Browse Articles

Subscribe
Notify of
16 Comments
Newest
Oldest Most Voted
Inline Feedbacks
View all comments

Free Newsletter

SHARE