This Is a Universal Impulse… and a Terrible Choice

Imagine this simple scenario…

Say you own two stocks. You bought each at $50 a share. Over the course of your investment, one has risen to $75 per share. The other has fallen to $25.

Suddenly, you and your spouse decide you need to raise money for something immediately. Perhaps a car you’ve wanted is on sale at the local dealer, or a cabin on a lake where you want to retire is suddenly on the market. You decide to sell one of your investments. But which stock do you sell?

If you’re like most people, you choose to “capture” your gains… sell the $75 winner and keep holding the $25 loser. You may think the loser stock seems to have more upside potential, and you’ve probably been waiting to “get even” on the position…

It’s a nearly universal impulse… but it’s a terrible investing choice.

We love to sell our winners too soon and ride our losers too long. A slew of behavioral finance studies show it. One, by University of California at Berkeley professor Terry Odean, found investors are almost twice as likely (1.7 times) to sell a winning stock as they are to sell a losing stock.

Following similar logic (urges, really), investors held losing stocks for 124 days and unloaded their winning stocks after 102 days.

But you may wonder, “Maybe the winning stock had grown overvalued and its gains were behind it.”

It turns out, the winning stocks (which had been sold) subsequently outperformed the losing ones (which investors were still holding).

It depends on what time frame you look at, but the general consensus is that over six- to eight-month periods, stocks that are moving up tend to keep moving up, and stocks that are falling keep falling. It’s a phenomenon called “autocorrelation.”

This confirms the old adage: “Let your winners run, and cut your losers short.

What the ‘Eternal Optimists’ Get Right

When most people buy a stock, they worry about what to do if it falls. But dealing with rising stocks presents an equal challenge. This blind spot in the human psyche regularly worried Peter Lynch.

Lynch is an investing legend. He averaged 29% annual returns over the 13 years he ran Fidelity’s Magellan Fund. He was also an eternal optimist when it came to buying stocks. His analysts joked that he “never met a stock he didn’t like,” and his fund swelled to more than 1,400 holdings.

Of course, no individual investor should try to manage 140 positions, let alone 1,400. But the point is… Lynch had a different outlook on the market than most folks. Once an investment shows a little gain, fearful ideas permeate our thoughts. Any little bit of news – good or bad – seems like a reason to lock in gains.

But as Lynch said, “We’ve been warned that a rise in oil prices is a terrible thing and a fall in oil prices is a terrible thing; that a strong dollar is a bad omen and a weak dollar is a bad omen; that a drop in the money supply is cause for alarm and an increase in the money supply is cause for alarm.”

Research shows a strategy that buys the 10% of stocks with the highest returns over the previous month and sells the 10% of stocks with the lowest returns in the past month generates about 1% a month – roughly double the expected return on the market. In other words, momentum wins out.

Other studies show stocks that hit a new 52-week high are more likely to outpace the market in the following week… not fall back down.

There’s no single rule that will tell you when to sell… And that’s because there’s no rule that tells you when to buy.

We discussed the importance of setting an “exit strategy” in our monthly Retirement Millionaire newsletter. At the heart of our advice is this…

The strategy for selling is determined by the reason you bought in the first place – and should be determined at the time of your initial investment.

When you buy a stock, it’s critical to know exactly what you expect to get out of the investment and what would lead you to sell…

Here are three keys that help…

  1. Write down WHY you bought it.
  1. Write down WHEN you’ll sell it.
  1. Review your investment at least once a year (but preferably every six months).

One trick I use to make sure I stick with my discipline is to ask myself whether I’d buy more right now or recommend the investment to friends or family. If the answer is no, it’s probably time to sell.

If I’m really worried that I’m making a mistake… I remind myself that I can always open a new position after a 30- or 60-day break. There’s nothing magical about the time frame. It just serves as a cooling-off period for my emotions. And most likely, a good investment will still be attractive at that point. And in many cases, I’ve found better opportunities by then.

There are plenty of valid “sell signals” you can use to cut short your losers. But trailing stops are also a simple, easy-to-understand way to eliminate your emotions and get out of losing positions before they get too large.

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