A conversation with an acquaintance of mine had the man mention his investment in Tesla (NASDAQ:TSLA) at $35 and his sale of three quarters the shares under his control at $150. Today TSLA trades at $237 per share. The story prompted immediate recollection of some value investor's belief that the ideal holding period for a stock is "forever." Why do we so often sell too soon?
The Cost Of Selling Too Soon
My acquaintance, Gere, collected $150 per share, and his returns were 428% (returns = $150/$35). Considering a tax of 20% on the profits, his trade resulted in an actual return of 362% (the result of ((($150 - $35) * (1 - .80) + $35)/$35) * 100 and represented as a percentage). Gere scored a return on investment of 362%!
That's great, but today he is feeling some regrets anytime he gets wind of the TSLA stock quote. Today's price of $237, represents a return of 677% on a purchase made at $35.
A return of 362% when Gere could pocket 561% (after tax) today if only he held on a bit longer!
What Went Wrong
Now, Gere didn't mention any pressing need or opportunity for the $22,500 he cashed out, it was just an expensive opportunity at possessing $17,250 after tax (and money now burning a hole in his pocket at that). Gere's telling of his story didn't continue after the point of sale. However, you might easily imagine the swiftness with which a person in Gere's shoes could quickly turn their tale of a 362% return into a capital tragedy by moving the cash into an inferior investment or otherwise blowing the cash. When the money isn't needed, why do we sell too early?
True Or False: I Have Not Lost Yet, Therefore, I Have Won (If I Flee Now)
There are times when the correct answer to the above question is "true" (like when encountering a hungry tiger in the wild, and when you are very uncertain of a stock company's likely future trading price). When the above question is given in context of selling a stock too early the answer is clearly "false." Because an investor loses badly to the taxman on early sales. What really causes the investor to fall into too early sales? Psychologists call the underpinning behavioural patterning by the term "Loss Aversion."
Don't fight a tiger, Do ride out your aversion to loss
It's occasionally the right time to sell a stock, after all. Please review carefully and ensure an unfounded fear of loss is not driving your next sale.
Knowing Is Half The Battle
It's clear loss aversion drives a lot of stock selling. A seller's uncertainty about the likely price of the stock in the future always fuels loss aversion. When there is no pressing need for the cash proceeds of a sale, submitting to the reflexive fear is very costly for investors.
How many folks have unnecessarily sold Berkshire Hathaway (BRK.A, BRK.B) over the years! They paid taxes on their gains and missed out on hard to beat compounding of nearly 20% per year on their capital.
There are three ways a person gets burned by a sale made too early. By taxes, opportunity cost, and by their ego whenever they are reminded of the situation. The ego often bares the blame for such a sale in the first place! Upon reflection, one finds doubts rather than a verdict based on knowledge of the stock and a reasonable weighting of possible price outcomes at the center of the too-early sale's decision. Investors in a panic are likely to act on doubts stirred up by loss aversion. Investors need to avoid entering a panicked state in order to avoid selling stock at the wrong time.
How To Enter A Panic
Checking a security's price too often. Entertaining unfounded doubts. Being unprepared for what Black Swan events may do to your investment portfolio (in terms of shaking up market prices or income streams). Lack of a clear investment thesis. Not knowing something and being unable to accommodate the missing information. Avoid panicking and boost your investment returns by not doing the four things to enter a panic listed above.
Norms, Surprises, And Causes
Loss aversion is a reflexively triggered cognitive bias and strikes both when sales will result in gains or losses. In fact, loss aversion is equal opportunity, also striking before investments are made as well as when sales will result in break-even returns are available. Because this is true of loss aversion, the investor must focus not on its elimination, but on reducing the time we feel threatened by the reflexive dread of losing money on a stock.
An investor who is uncomfortable with their portfolio holdings amplifies the likelihood their nerves will blow up a tolerable doubt about a great investment into a large, threatening, and imaginary monster calling for the too early sale. When the portfolio is right, one is able to think normally about the whole investment thesis in play (so long as an unpanicked state becomes the norm). Additionally, the pangs of loss aversion coming on in reaction to surprising data will be more tolerable. A cool evaluation of the facts is performed by a cool head.
The breaking news on fake accounts produced by Wells Fargo (NYSE:WFC) employees is an example of surprise; Black Swan data requiring the investment thesis be accurately evaluated in light of new facts.
A decision to sell too early may be blamed on any single or collection of causes. And while not every sale said to have been made too early is a mistake, they very often are made in error. You and I may be helpless to cancel the loss aversion reflex, so we can adapt by preventing panicked amplifications of doubts into causes.
Managing The Investment Portfolio
Now a few words on how I manage myself in order to avoid spending my time vulnerable to panic. The central element is a strong financial portfolio in order to avoid undue stress. To that end, I have barbelled my holdings between "zero risk" assets and "risky" assets. Zero risk assets means I'm holding T-Bills and cash (NOT held in a money market or cash sweep account). I have the full faith and credit of the U.S. Government behind this "zero risk" portion of the portfolio, through the T-Bill and bank deposit insurance.
On the other half of the barbell portfolio, I have my risky assets. Stocks, bonds, options.
Having several years' expenses of cash equivalents held in my portfolio gives me the peace of mind that I will survive a crash or Black Swan event threatening my risky holdings.
In my experience, the investor who hasn't squared away the quiet panic of being financially vulnerable will hurt their investment returns with overactive buying and selling, and all the troubles we've discussed throughout this article.
Each investor needs to determine what ratio of "zero risk" and "risky" assets is right for them. The very conservative may target 90% cash and equivalents, while the younger and more aggressive may appropriately trade with 25% cash.
Don't feel too bad for Gere. In the end, the choice to retain 1/4th of his position in TSLA stock shows he believes it may continue to run.
Please click the + icon next to my user name and follow me, Faloh Investment, as I work to keep you informed on further developments as the market continues to present major value opportunities.
This is not a recommendation to buy or sell any security.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.