Buying stocks is easy, but selling? That’s when things get tricky, according to new research.
It’s well -known that most fund managers don’t beat the stock market. Researchers have generally argued that most active managers are not sufficiently skilled to compensate for the extra costs incurred by their research and trading activities. But a new study suggests that’s not the full story.
It turns out professional investors are very good at picking stocks and know how to buy; the trouble is, they’re just awful when it comes to selling.
Most research into biased financial decision-making has tended to focus on mistakes made by ordinary investors with modest portfolios, note the authors of the study, Selling Fast and Buying Slow. To see if professional investors were similarly guilty, they analysed 4.4 million trades and 783 portfolios with an average value of $573 million over a 17-year period, between 2000 and 2016.
The results were striking. Renowned finance professor Burton Malkiel famously said a chimp throwing darts at the Wall Street Journal could create a portfolio as good as the experts, but this study suggests otherwise. When it came to buying decisions, fund managers added value. They handsomely outperformed a randomly constructed alternative portfolio that acted as a control group, suggesting these were highly skilled investors who had done their homework.
However, this financial advantage and more was wiped out by lousy decisions when it came to selling.
In fact, the fund managers would have done much better if they had randomly sold their holdings, without putting any thought into the matter whatsoever. Put another way: they should have called on Malkiel’s chimp to do the selling.
Focus
What’s going on? Why are professional investors good at buying but awful at selling? A variety of factors are likely involved, but the main one is quite simple. Fund managers “do not lack the fundamental skills to sell well, they are just not paying attention”, say the authors.
Most of their time is devoted to finding the next winner to add to their portfolio, on finding the “next great idea”. Not nearly as much time goes into sales decisions. “They viewed selling as necessary in order to buy”, the study says, as a way to raise cash for new purchases.
Fund managers admitted as much to the authors. “Selling is simply a cash-raising exercise for the next buying idea,” one said. “Buying is an investment decision, selling is something else,” said another.
This cavalier attitude is dangerous, given the data suggests the less time devoted to selling, the worse the results. The study notes sales decisions are “particularly poor” when managers sell large bundles of stocks at the same time compared with when they sell solitary stocks. In the former case, the managers are likely selling to raise cash whereas sales of individual stocks are more likely to be driven by fundamental considerations.
When managers are stressed, they appear to spend even less time considering stock sales; the worse a fund’s quarterly performance, the authors found, the worse their sales decisions.
The importance of paying close attention to stock sales is also highlighted by activity during earnings season. When companies are reporting earnings, the authors suggest, managers are likely to be paying as much attention to potential stock sales as they are to potential buys. During this period, their sales decisions are as successful as their buying decisions, indicating managers have the ability to sell well – they just don’t devote enough time to it outside of earnings season.
Tracking
For the same reason, fund managers are unlikely to learn from their selling mistakes. Purchased stocks are closely tracked, providing valuable and frequent feedback on the outcomes of buying decisions. In contrast, “paltry resources are devoted to decisions of what to sell”, with anecdotal evidence suggesting sold stocks are “rarely, if ever” tracked to calculate returns forgone.
“When I sell, I’m done with it,” one manager told the authors. “In fact, after I sell, I go through and delete the name of the position from the entire research universe.”
As other researchers have argued, buying and selling may be driven by “two distinct psychological processes”: purchase decisions are more belief-driven and forward-looking, while sales are backward-looking, with managers relying on a simple rule of thumb when deciding what to sell – past returns.
Managers are much more likely to sell stocks with extreme returns, with the best or worst-performing stocks more than 50 per cent more likely to be sold than stocks that have only slightly overperformed or underperformed. Such sales, the study suggests, allow managers to “psychologically rationalise” their choice.
However, selling a stock merely because it moved up or down by a lot is not a good idea (this may be especially true of stocks that have risen a large amount, given much research indicates that stocks exhibiting strong momentum tend to continue outperforming). The managers most prone to this tendency would, the study finds, earn up to an extra two percentage points annually if they got a chimp to do the selling.
Implications
These findings have important implications. Firstly, previous research has found ordinary investors are undermined by various behavioural foibles (overconfidence, inattention and a desire for excitement, among others), but it’s clear professionals are bedevilled by many of the same problems.
Secondly, it’s safe to assume that ordinary investors who like to dabble in stocks also spend much more time thinking about what to buy than what to sell, but the message of this study is unequivocal – you are losing money by not paying pay more attention to your selling decisions.
Thirdly, researchers need to spend more time thinking about how to improve sales decisions. Commenting on the study on Twitter, Nobel economist Richard Thaler said academics "may be to blame" for fund managers' poor sales decisions. "Nearly all academic papers on investing are about 'buying' strategies, usually using fixed holding periods," added Thaler. "Nothing on selling."
Finally, it’s patently obvious active managers need to up their game in this area.
The active management industry continues to lose market share to passive funds, which track market indices for a fraction of the cost. The main reason for that is simple – investors are increasingly aware the vast majority of active fund managers fail to justify their fees and underperform the market. However, this latest study suggests many managers are skilled investors who earn their keep when it comes to buying, only to let their clients down by paying scant attention when it comes to selling. Keeping track of the performance of sold stocks, adopting new learning tools and experimenting with simple alternative strategies would, the authors say, “substantially improve performance”.
Indeed, the managers most prone to selling stocks with extreme returns would actually generate “substantially greater earnings than the average management fees charged to clients” were they to simply adopt a random selling strategy – that is, the dart-throwing chimp approach.
Such a strategy is unlikely to be adopted by the active management industry – no doubt, it would be a hard sell to clients who expect a more sophisticated approach. But the stark reality is that a random sales strategy is better than a bad sales strategy.
