Here, Michael Taylor (@vilage_idoit) – author at shiftingshares.com – takes a look at how private investors can benefit from the following piece of academic research on the selling habits of institutional investors:
Akepanidtaworn, Klakow and Di Mascio, Rick and Imas, Alex and Schmidt, Lawrence, Selling Fast and Buying Slow: Heuristics and Trading Performance of Institutional Investors (December 2018). Available at SSRN: https://ssrn.com/abstract=3301277 or http://dx.doi.org/10.2139/ssrn.3301277
Most money managers are good at buying stocks; however, they are absolutely terrible at selling them. With this in mind, Akepanidtaworn, Di Mascio, Imas, and Schmidt’s study found that portfolio managers would be better off, and in some instances significantly better off, if they sold off their holdings at random.
It is possible to make money from a random entry trading system as long as the exits are controlled. However, this is the first piece of research I have seen that suggests random selling. Indeed, as one extract from the work puts it:
“While investors display clear skill in buying, their selling decisions underperform substantially — even relative to strategies involving no skill such as randomly selling existing positions – in terms of both benchmark-adjusted and risk-adjusted returns.”
The problem around selling arises because most investors place emphasis on their buying. They do the research, they study what a stock’s net asset value is, and they compute complex discounted cash flows on its expected earnings and cash flows. Much effort goes into the buy side.
However, the other side of the trade is the sell, or the exit. Private investors often suffer from behavioral biases here such as endowment bias, loss aversion, and greed. But the study found that many of the professionals were no different in their actions when it came to selling. They too were restricted by the same problems and errors that blight private investor portfolios, despite an increased knowledge of these errors.
“A striking finding emerges: while investors display skill in buying, their selling decisions underperform substantially – even relative to random sell strategies. A salience heuristic explains the underperformance: investors are prone to sell assets with extreme returns. This strategy is a mistake, resulting in substantial losses relative to randomly selling assets to raise the same amount of money.”
The problem noted in the above extract comes down to the classic investing mistake of cutting winners and running losers. The salience heuristic means we kill winning trades far too early, and, as a direct result, keep the losers running for longer. Executing a random sell strategy would have removed this heuristic and bolstered portfolio performance.
Of course, with the fees (in some cases exorbitant fees) many fund managers take, perhaps their clients would not be pleased to hear that, instead of selling at the fund manager’s discretion, their money would be better off if sell decisions were made on a coin toss. On the other hand, people don’t like to hear that they’ve been wasting their money. As such, many clients would likely reject the conclusions.
The fact is that most fund managers lack any objective analytical framework for selling positions, and instead use very subjective rules or gut instinct. Unsurprisingly, neither of these yield a great deal of success. The study found that the most common reason to sell was to the buy the next investment idea!
The data looked at the daily holdings and trades of 783 portfolios that contained an average value of roughly $573 million. Over 4.4 million trades were analysed and the study ran from 2000 to 2016, a period covering both Dotcom and the 2008 Financial Crisis. The length of the study increases its significance as it removes any doubt over just picking a rosy period in the stock market. During this period, we have had the largest bull run in history but two of the worst stock market crashes also.
Researchers evaluated performance in a clever way. Instead of using a benchmark as usual, they created a counterfactual sell portfolio, in which a random security was sold whenever the portfolio manager sold a security in real life. Sadly, the counterfactual sell portfolio consistently outperformed the actual fund manager, raising the question: what do we actually pay them for?
What does this mean for private investors?
The implications of this study are clear. As private investors, we need to be much more aware of our sells and know that we are likely actively damaging our returns if we aren’t randomly selling our positions. We should learn about the biases and construct rigid and robust selling plans immediately after purchasing the stock. Most private investors and fund managers do not put as much thought into the exit as they do the entry, and this is costing them in real money terms.
Author: Michael Taylor
You can hear more of Michael’s thoughts at his fantastic ShiftingShares blog, located at https://www.shiftingshares.com/