Do due diligence well before selling a stock

Over the week, I was interacting with one of my clients and he shared his recent investing experience with me. I found it’s true with many of others as well. He did an exhaustive study over a particular stock before taking a position. He went an extra mile of doing a bit of ‘investigation’, as he calls it, on research published by that particular company in the past five years.

He painstakingly plots a trendline and sees that it had increased tremendously in the last year. He was sure of good results from the recent quarter. So, when the stock started to slide before the earnings call, he became nervous and sold his entire position and the stock went up in double digit percentage in a single trading day. He said he probably needed extra conviction to ride that itch that cost him the opportunity loss.

What I have realised is that a very critical aspect of stock investing other than picking the right stock, doing the due diligence, sticking to a philosophy and adhering to a balanced behaviour is knowing when to exit. We find a lot of literature and perspectives on how to identify stocks, what to invest and when to invest but a very negligible information on when to sell, what! Most times the portfolio returns actually depend upon the fact that owning or not owning a particular stock(s) at a given point of time defines the entire performance. I think the repeated calls for not timing the markets is apt even while selling, because one may end up timing it wrong.

Despite all the hard work of research and strict adherence to discipline, we are prone to make mistakes and it’s not just confined with retail investors. Bloomberg last week summarised a recent survey of institutional investors as, “Stock-Pickers don’t know how to sell. They actually do OK figuring out what to buy. But they need to do a better job unloading stuff.” A research paper, “Selling Fast and Buying Slow: Heuristics and Trading Performance of Institutional Investors” has used the data set to show that financial experts - institutional investors with portfolios averaging $573 million - exhibit costly, systematic biases.

The paper finds that while these investors display clear skills in buying, their selling decisions underperform substantially in terms of both benchmark-adjusted and risk-adjusted returns. The findings are even more stark as these decisions have underperformed even to strategies involving no skill such as a randomly selling existing position. The study found that many professional managers are subjected to suffer from behavioural biases as any other retail investor.

The study highlights the crude use of randomness and gut-instincts by professional fund managers while selling a stock which are counterproductive for the portfolio performance. The study includes a data set of trades of 783 portfolios, evaluated across over 89 million trading data points and 4.4 million trades. The study encompassed over a period of 15 years between 2000 and 2016 which witnessed at least two spectacular market crashes, two stunning recoveries. Overall, the research considered 2 million sells and 2.4 million buys made by institutional portfolio managers.

What the researchers did is to record the performance of the counterfactual portfolio to randomly sell a different security each time the actual portfolio manager sells a particular security. The results were stunning as the random sale portfolio consistently outperformed the managed portfolio by 50 to 100 basis points over the course of the following year. And the researchers also tried their luck with the random portfolio management for buys. It underperformed the active strategies.

Thus, the paper concludes that this is due to limited attention as a key driver of this discrepancy. When attentional resources are more likely to be equally distributed between prospective purchases and sales, specifically around company earnings announcement days -- stocks sold outperform counterfactual strategies similar to buys. Assets with extreme returns are more than 50 per cent likely to be sold than those just under- or over-performed. Finally, it concludes that the use of heuristic appears to be a mistake and is linked empirically with substantial overall underperformance in selling.

So, my client’s predicament over the sell call is understood but seems part of our behavioural issue and so could be mended. It’s hence equally important for us to give an essential analysis and research while selling a stock as when buying. We need to follow a process of evaluating when selling, elaborating the reasons to sell and document the various behavioural patterns, feelings, etc. while arriving at the decision. This would form a guide when a similar situation arrives, we could possibly improve our decision making and judgement.

- K Naresh Kumar
(The author is a co-founder of “Wealocity”, a wealth management firm and could be reached at knk@wealocity.com)