The Selling Process Part 3 1 comments
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Previous parts (Part 1, Part 2) have discussed the issues with selling a stock on which one has hitherto made a profit, as well as a stock which has remained stagnant for a long period post-purchase. What about stocks that have disappointed the investor by dipping, or even plunging, below his original purchase price?
Selling in this case is of course, known as cutting loss. From personal experience, selling losers is as psychologically difficult as selling winners, if not more so; selling stagnant stocks might be easier on the mind. This is a well-documented and well-tested phenomenon; behavioural studies have shown that people suffer a greater amount of grief from losing money than pleasure from gaining a similar amount (a phenonenon known as diminishing marginal utility of wealth). If losing money causes them so much grief, the tendency is of course to postpone the decision that will transform paper loss to actual loss. The implication is that one needs more self-discipline in selling losers.
The standard advice is generally to think from a third-person perspective and imagine if one would purchase the stock if he was not already vested in it. However we're all human; how objective can we be and how do we know that we are being objective in our opinions about the stock? That's the paradox. My view is that it usually pays to be cynical rather than hopeful. Companies usually want to portray their prospects in a good light and generally will want to release good news and financial reports; it facilitates good valuations and future fund-raising exercises on the capital market. So if they are unable to do so, one adage comes to mind: a cockroach on the kitchen floor suggests many more in the closet. That is why in the US, companies' stock prices are punished heavily, apparently even disproportionately, if their earnings miss estimates by even one penny.
To me, profit-taking tends to be based on quantitative evaluation, while loss-cutting should be based on qualitative assessments. Stocks that have run up tend to have undergone an optimistic revaluation by the market, and the investor might be sufficiently swayed by such market optimism and glowing reports of future prospects that he decides to postpone selling. In this, he thinks he is practising the axiom "let the profits run"..... which might not be wrong, but could be dangerous if there is no continual re-assessment of the valuation-risk-prospects triumvirate. Hence a reality check is often to revert to quantitative figures of P/E, P/NTA, dividend yield etc; by the guiding law of means reversion no small-cap should be worth more than 20X P/E, for example. On the other hand, if one had bought at fair valuations in the first place, a stock that had depreciated downwards from original purchase price would have even more compelling valuations from quantitative perspectives eg. P/E. These tend to dissuade the investor from selling.
That is where qualitative indications, in the form of danger signs, should be focused on instead. Consider a path flanked by coconut trees. Would you walk along the path if you see several coconuts lying along the path, obviously having dropped from above? Although this path is the swiftest, you would probably take a detour. The danger signs are there. A scenario where the coconuts are literally dropping down in front of you is no longer suggestive; it is the real thing and it would be too late to do anything by then. The idea is therefore to read the signs and get out, without being seduced by the idea of a cheap and quick path to financial freedom.
Danger signs vary; several examples would be drastic fall in price despite seemingly strong business (eg, ACCS), resignations (especially key personnel), earnings below expectations, delayed financials announcements (usually bad), reverse splits, regulatory actions.... (drawn from the book "Streetsmart Guide to Short Selling"). The list is not exhaustive, and one should exercise contextual judgment. Again, Warren Buffett's advice that risk should decline as price falls is relevant sometimes, but the key thing is that one should not be seduced by the quantitative factors alone in making/postponing cut-loss decisions. He should also not let fear of regret deter him from making such a decision. After all, he is only selling at what the market is currently quoting, and if he takes the position that the market is efficient in the short-term, then it makes sense to divert resources to stocks which have better prospects in the medium term (and there should be some around!).