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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.

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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.

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Gary Palmer
Gary Palmer
1 month ago

I stopped buying individual stocks years ago, when my Fidelity mutual funds performance used to fall below their bench mark every single quarter. I decided to just buy the benchmark, simple. That removes you from the insanity of buying and selling based on relative prices. Alpha is a pipedream.

johntlim
johntlim
1 month ago
Reply to  Gary Palmer

Good for you Gary! An added bonus of the “buy the market approach”: a great deal of time saved researching individual stocks.

Gary Palmer
Gary Palmer
1 month ago

Investors are taught that you have to buy low and sell high, so when the price looks high, they sell. They are buying and selling because of the price, not the fundamental future profit expectation.

Gary Palmer
Gary Palmer
1 month ago

Amen. I quit the investment club I was in because the majority was too quick to sell our winners. I tried to convince them that if you sell your winners you only have losers left, and the odds are against you when you reinvest the proceeds of that sale. That is, your reinvestment will have to perform better than the winner that you sold, not very favorable odds. I couldn’t convince them that the only rational reason to sell a winner is when you believe their has been a negative fundamental change in the company’s expected future profitability. The club’s performance was poor, with many more losers than winners.

macropundit
macropundit
2 months ago

>> … just 4% of stocks—we’ll call them the winners—account for the lion’s share of stock market returns … if you’re picking individual stocks, your odds aren’t great.

But this 4% often always contains some monster stocks that are also household names and run for many decades. It’s a psychological challenge–though attainable for the prepared–to hold onto these monster stocks over time. But the fact that only 4% of stocks outperform doesn’t have as much to do with one’s odds of finding one as people assume, simply because it’s not random.

On the one hand most people should be in index funds as Buffett says. But for those who do pick stocks, assuming randomness is distorting because it’s not how people do it.

johntlim
johntlim
1 month ago
Reply to  macropundit

Good points. I would point out that the “top dogs” (top 10 market cap companies) in one decade rarely stay at the top of the heap in future decades. Research Affiliates has a good piece about this, which you can find here:

https://www.researchaffiliates.com/publications/articles/830-the-fall-of-the-titans

manager
manager
2 months ago

In addition to the case laid out by the Bessembinder study, employment of the investment 101 principle of “diversification” and use of the large cap “value” factor, can help eliminate the urge towards individual “stock picking”.

For an investor in their “income” or retirement stage who wants to create and manage a flexible income stream in a simple fashion, research shows that a portfolio / index representative of the Large cap value has sustained a “7%” inflation adjusted annual withdrawal rate ( “sale of shares”, dividends reinvested ), accompanied by terminal portfolio growth, over seventy one rolling 20 year periods since 1932 https://tinyurl.com/y6key3v5 . And this income stream survived World Wars, recessions, a myriad of geopolitical and economic environments, pandemic?, etc.

A modern investor is fortunate to have available well diversified, large cap value index funds ( such as the low expense Vanguard Value ( VTV ) mentioned, the DFA Large Cap Value, Fidelity Value Factor, etc. ), which may be used for this purpose. And rather than putting in an inordinate amount of time focusing on individual “winners” or “losers”, the aggregate portfolio appreciation and dividend contributions of hundreds of companies allows for a more flexible and tailored income stream, with the portfolio being managed through professional expertise.

Steve Spinella
Steve Spinella
2 months ago

I’m having trouble following the logical connection between the paper and the investment advice. To put it another way, I hear the unstated premise is that we must own the bottom half of the market in order to have an above average chance of owning the top 4%. That sounds like a pretty big premise. What other things might we be able to do to have an above average chance of owning the top 4%, or even the top half of the market? While it is possible to make a truly random walk down Wall Street, even the most absent-minded pedestrian is surely going to notice some things of interest that draw their attention more than others. Of course, it is also true that the person who sits on their porch will not notice anything out of sight from the porch. And while Warren Buffett might prefer to hold stocks forever, he regularly both adjusts his positions and selects from what he believes is the top half of the market, based on, as John notes in his last paragraph, a focus on the fundamentals.
So, in summary, I would say that the research cited could just as easily be used to support a choice not to own the whole market based on an awareness that even imperfect analysis might lead to an above average concentration on the top half of the market.
What we can say for sure is that not all stocks and not all companies will be winners, even though the average return of such companies and stocks handily beats the return of the one-month T bill.

booch221
booch221
2 months ago

I’m a firm believer in owning index funds but I do own one actively managed mutual fund, the Vanguard Wellesley Income Fund (VWINX). Since its inception in 1970 it’s averaged a 9.71% return. It’s 40% stocks and 60% bonds. The fund managers must know how to pick them.

John Wood
John Wood
2 months ago

Thanks for the interesting article, John, and it points to an investment axiom that I’ve long been suspicous of: What is portfolio rebalancing, if not a systemic error of selling one’s winners to load up on the losers?

johntlim
johntlim
1 month ago
Reply to  John Wood

I think that rebalancing has great merit, especially in managing risk. Take, for example, a 60/40 portfolio (60% stocks/40% bonds) that morphs into a 75%/25% portfolio during a bull market. By rebalancing, you lower risk and, if you’re lucky, may even boost returns somewhat, if there is market volatility. But, I think rebalancing is primarily a risk management tool, not a way to boost returns. In fact, you will always regret rebalancing during a prolonged bull market. Again, no free lunches…

booch221
booch221
2 months ago
Reply to  John Wood

But you’re not selling ALL of your winners when you rebalance an index fund, just a small percentage of them, you’re also selling a small percentage of your losers.

Subhajyoti Bandyopadhyay
Subhajyoti Bandyopadhyay
2 months ago

I was relieved when I read the article. If there were lots of winners (and therefore lots of losers to balance them out – a winner or a loser is measured with respect to the average, after all), then the stock market is doing a poor job. A good market is where most companies are getting “market returns” – not great (because that would have attracted competition in their market segment), not bad (because that would mean that they are satisfying some (main street) market segments and yet the (stock) market is not rewarding their performance), but just about average in the long run. And there should be just a few segments of the market that will lack – hopefully, temporarily – enough competition, which is where we see the few sustained winners.

At every point in time, there will be some companies that come along with a breakthrough product. And for a while, there is nothing like that product in the (main street) market, which is why its stock delivers above-average returns (hopefully, that period is relatively brief because the stock market would have internalized this outperformance relatively quickly). And then other companies come along with products that are either me-too (so price competition increases) or are such that they obviate the need for the product (typewriters after PCs). And so we have the next cycle of winners. The only way that companies can continue to deliver above-average returns for a sustained period is if they have some sort of “external support” that limits entrants – like in the healthcare industry.

(The current crop of “FAANGM” stocks does make this cycle a bit more difficult because of their network effects (and data network effects), but who knows…)

All of which brings us back to the same boring conclusion – unless you have a damn good set of eyes to spot either (a) the next big thing or (b) are eagle-eyed to observe the arbitrage opportunities in the (stock) market because it has temporarily underpriced an asset, you are best left holding large index funds that mimic the market at the lowest possible cost.

Last edited 2 months ago by Subhajyoti Bandyopadhyay
macropundit
macropundit
2 months ago

>> The only way that companies can continue to deliver above-average returns for a sustained period is if they have some sort of “external support” that limits entrants – like in the healthcare industry.

Generally yes, but I’d say though exceptional sometimes there are moats not based on “external support”. Take Toyota or Apple (post-Jobs). I’d say they are both cases of a management revolution. If you were early investors in either it would very likely have been because of a belief their management teams and company structures–based on their revolutionary beliefs. So much so that other companies don’t even wish to emulate what the management of these companies are doing, but rather hope to avoid it and wait until some future external disruption levels the playing field again so they’ll have a chance to compete.

>> unless you have a damn good set of eyes to spot either (a) the next big thing or (b) are eagle-eyed to observe the arbitrage opportunities in the (stock) market because it has temporarily underpriced an asset, you are best left holding large index funds that mimic the market at the lowest possible cost.

I think this is excellent advice. Seeing the next big thing is a matter of accident of the sort Peter Lynch spoke of. Having some deep knowledge due to experience. The thing is you can’t expect to find this sort of thing. But if you’re lucky enough to see it, and you can stand the risk, then you’d better take it.

The problem with the latter is that many people were talked out of such chances of a lifetime by those with a quant mindset who believe any particular knowledge could only hurt an investor. In reality any knowledge can end up hurting you, so that’s a lame pretext. Or they’ve been talked out of it by the newly formed financial advisory industrial complex, who preaches that diversification is a free lunch. Which basically means don’t buy too much of a good thing, which is counterintuitive for all the right reasons.

mcammer
mcammer
2 months ago

The reasons given here are precisely arguments for buying index funds and holding.

But I’d be interested in seeing the results for a fund that holds the top 50%, 25%, and 10% performers at any time, let’s call it a momentum fund, to approach the 4% of winners. Could you write about this?

Olin
Olin
2 months ago

Your articles are always excellent to read! Thanks for the reference links to Bessembinder and Kahnaman.

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