The old stock market saying “cut your losses and let your profits run” is also understandable to the layman and needs to be proven neither empirically nor theoretically. Nevertheless, stock portfolio managers have difficulties in following this guiding principle and its implementation is inadequate. These conclusions of the book “selling fast and buying slow“, published in 2018 by three academics from different US universities (K. Akepanidtaworn, A. Imas, L. Schmidt) in cooperation with the data company Inalytics give food for thought. After examining the daily activities of hundreds of portfolios over several years (> 2 million purchases and sales), they conclude that purchases have generally helped performance, while sales have had the opposite effect.

 

Share purchase

The purchase of a share is usually the result of a thorough analysis of quantitative and qualitative key figures. The quantitative assessment is usually sufficient for selecting markets, industries, sectors and themes, but becomes dangerous when selecting individual stocks. A well-known, large-capitalized company with good key figures for sales and earnings growth, dividend yield and book value does not necessarily have to be qualitative from the outset. This is precisely the weakness of IT solutions for investment advice and asset management, the results of which are only based on an in-depth analysis of quantitative figures.

Qualitative analysis is more difficult, as the word quality alone can have various meanings. Property, nature, quality and value level are all examples of the use of a term that Aristotle already identified as one of the basic philosophical categories (realism and idealism). In classical logic, quality means the differentiation between affirmative, negative or limiting statements about perception. Of course, an affirmative statement is indispensable for the purchase of shares, whereby the various meanings of the word quality would best be provided with the adjective “sustainable”.

 

Share sale

The sale of a share is usually not preceded by a careful analysis of the key figures, often on the assumption that nothing has changed since the purchase. If the share price has risen, this attitude is not necessarily correct, but it has no consequences. If the share price is lower, it is obvious that the analysis was wrong at the time of purchase, but it is unclear which component played the decisive role. Although it would be worthwhile to identify the mistake (learning effect), the circumstances (poor performance, market turbulence) often require a quick decision. Added to this are the human aspects: How long does it take until the “excuses” are no longer enough and the mistake has to be acknowledged?

A sale can be triggered by a change in strategy or tactics, asset allocation or sector rotation. However, the reasons for selling individual shares do not change. A sale is most common when a price already predetermined at the time of purchase is reached (target price). No new analysis is carried out and the risk of a new investment (reinvestment risk) arises.

 

Analysis of the purchase and sale decisions

It is noticeable that purchase decisions are always made rationally. The quantitative analysis of every conceivable key figure is carried out objectively and pragmatically, which makes the result very close to reality. Danger exists only in an arbitrarily chosen price and time axis, which can lead to a unique situation that is not representative. The main difficulty is the weighting of positive, neutral and negative ratios.

It is astonishing how emotionally sales decisions are made. With the exception of changing basic assumptions and reaching a predetermined share price, they are predominantly subjective, biased and one-sided. Falling share prices with up to 5% loss are explained as market fluctuations, those with up to 10% with one-off events and those with over 10% loss with irrationality of the market. Admitting mistakes takes time and the realization of a book loss even more.

 

Cut your losses and let your profits run

The investor is well advised to pay more attention to the selling decisions. A stock position should be periodically reviewed with the question “buy more” or “sell” and the answer should be implemented consistently. Losses are nothing unusual, but how they are handled is crucial. The handling of profits is equally important. The danger of realizing profits too early is high and can best be countered with partial sales; partial profits are realized and leave further potential open.

 

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Christian Wagner
Financial Advisor