How To Make Money In Stocks Part 5: Learning to sell

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It is my belief that if the retail investor does his research properly and bases his buying decisions on long-term business fundamentals coupled with a reasonable valuation, his downside is limited and he can expect the stock to eventually rise, whether on market realisation of the business potential, or on the margins hitting a sweet spot of the business cycle, or on management/fund buyouts reflecting insider/institutional awareness of the intrinsic value of the business. The key word is "eventually", because the time the investor has to wait for the stock to rise is unknown. But my point remains --- the patient investor will eventually see the stock gain some buying interest.

When that happens, another aspect of time becomes important for the investor: how long will the stock enjoy its place in the sun? Will it be just a short pump-and-dump operation by the big holders, or could the stock become one of those rare Cinderella stories and live happily forever?

There is a new branch of finance, known as behavioural finance, which essentially recognises the "humanness" of market participants that adversely affects their decision-making (as opposed to standard finance that assumes a "rational" investor). Behavioural finance sheds some light on human tendencies when faced with the above scenario. People tend to be overly-optimistic and have a fear of regret (ie. the stock soars after they sell) which leads them to hold rather than make any active decision to sell.

Hence, it is important to be aware of our own human nature and to consciously lean against its biases. In the case of what action to take when a particular stock holding rises substantially, sometimes it's better to let the profits run, sometimes it's better to lock in the profits, again there is no fixed rule, but it is my experience that selling is the most difficult thing to do for many people --- which is why patient investors might not make money in the end. Therefore an element of selling discipline is important to lock in the profits when they arise.

There are several other key factors why learning to sell is important, besides the abovementioned psychological bias.

Firstly, fundamental cyclical effects. This is a real danger of holding on too long to a stock that has risen substantially, and is particularly relevant for cyclical stocks like shipping, property, commodities, technology ...... or indeed in most sectors where product demand is discretionary and pricing is commodity-like (ie. the business is a price-taker rather than price-setter). Where profitability is highly dependent on industry prices which are in turn determined by demand-supply dynamics, the entire sector can come in for strong market attention when the pieces come into place at a particular part of the business cycle eg. technology at the early stages of recovery when inventory is low, production capacity is thin and consumer demand is growing at an increasing rate. The stock surges in response. But as manufacturers ramp up capacity and squeeze the margins, the product ASPs (average selling prices) can quickly fall even as raw material prices rise. If one misses selling at the sweet spot, he can be stuck for ages when the stock normalises. This is because capacity, once increased, is difficult to reduce until there is painful industry restructuring where smaller players exit ie. when losses become too hard to tolerate. The problem is that the level of tolerance of many business owners is very high.

The second main issue is market liquidity. How many times have we seen this: stock A, previously illiquid, gains some market attention on initiation of broker coverage (perhaps because the company is placing out new shares). The stock rises on optimism about the strength of its prospects, and fundamental investors accumulate. As volume picks up, the stock breaks past all resistances, attracting technical traders. The momentum carries it on day after day. Then it peaks, strangely on a day when good news came out and the stock failed to react. Classic "buy on rumour, sell on news". The stock retraces all the way back to where it came from, and liquidity dries away leaving the stock to the effects of gravity. And soon it becomes anonymous again as a new wave of market favourites take over. The loss of market liquidity, sometimes unrelated to intrinsic fundamentals but nearly always linked to sudden market-wide realisation of expensive valuations plus withdrawal of strong-hand support, is another reversion-to-mean effect that is often difficult to reverse and exacts high opportunity cost for the late-to-sell investor.

The devastating psychological effects on the investor should he endure an up-down cycle without anything to show for it cannot be ignored either. Those who have experienced it will know what I mean. Failing to sell at the peak, he will find it harder to sell at 10% down, even harder to sell at 20% down and hence arises the terrible situation where the more the stock drops, the more unlikely the investor will sell. That is because he had already mentally anchored his wealth at the peak of the stock's valuation. It is important not to let this happen too often, because it can eat into one's confidence and affect future decision-making.

The above reasons suggest that profit-taking, though not always leading to an implementation decision, should always be at the back of the investor's mind when a particular stock holding surges. Quite often, the most painful thing to do is the right one. Introducing some selling discipline, such as selling a portion of one's holdings once the stock reaches a particular valuation waypoint, say 15X PE (or whatever one deems a fair valuation), might be useful in altering the psychological state-of-mind and facilitate further liquidation on perceived peaking of fundamentals and/or momentum etc. This is in recognition of the fact that selling is as much a psychological issue as one based on financial evaluations.

And then again, letting the profits run might be the best thing to do in some cases. Without adding to the confusion, I will just point out that it happens less often and also that some find it prudent to set some moving sell-point that is say, 10% below the peak, so that even if one intends to ride the long-term momentum, he will be stopped out by a sizeable adjustment from the peak. The level of tolerance, and hence the maximum drawdown limit where one sets his sell-point, varies from individual to individual and from stock to stock, depending on the level of confidence about its long-term strength.