You'll Never Grow Rich Taking A Profit

Friday, Jan 31 2014 by
11

“I made up my mind to be wise and play carefully, conservatively. Everybody knew that the way to do that was to take profits and buy back your stocks on reactions. And that is precisely what I did, or rather what I tried to do.....

They say you never grow broke taking profits. No, you don't. But neither do you grow rich taking a four point profit in a bull market.”

Jessie Livermore, Reminiscences of a Stock Operator

Orgasmic Trades 

We hate taking a loss, so taking a profit is always good, we usually think.  After all, we’ve locked in our profits, so we can never take a loss on them.  Which is all well and good, if you have a continuous stream of brilliant investing ideas, such that you can replace the stock you’ve sold with one that’s better.

This is worse than loose thinking, it’s not thinking at all.  It’s not the profit we’ve made we should worry about, but the profit we’ve foregone.  It’s the opportunity cost of selling a profitable stock we should be concerned over, not the transient orgasm that comes with the brief thrill of a quick gain. 

“You never go broke taking a profit” is a horrible, thoughtless, dumb investing aphorism that deserves to be consigned to the Satanic fires along with tipsheets and day trading.  It’s true, of course, but it justifies a whole raft of otherwise indefensible, idiotic and perverse trading behavior.  ­ Worse still, it panders to one of our most fundamental behavioral weaknesses, loss aversion.  We just hate selling at a loss, so we will grimly hang on to loss making stocks. 

The disposition effect, which is an outcome of loss aversion, adds to this the nasty twist that we tend to sell our winning stocks too soon – which means we no longer run the risk of a loss on that stock (see Brains, Bulls and Lucky Tossers).  Of course, the problem is that we only track the stocks we hold.  So here’s a tip: keep tracking the stocks you've sold and see what the results are.  I can tell you one result – you’ll suffer from an alternative behavioral bias, regret. 

The general idea about these biases is that they cause us actual pain.  So selling at a loss hurts, and we can avoid the hurt by refusing to sell.  And tracking the stocks we've sold and seeing them soar also hurts – and we avoid that particular experience by simply ignoring the stocks and hoping they'll go away.  Although if we do track them we still won’t repurchase them if they go higher, as Michal Strahilevitz, Terrance Odean and Brad Barber showed in Once Burned, Twice Shy.

That we engage in this peculiar behavior isn't really in question, but why we do it is another matter.  Economists would traditionally argue that we should operate in a way that ensures we gain the maximum utility from our trading behavior – which in that instance roughly equates to maximizing our capital.  But, as you might observe, even allowing for an element of hindsight and the limitations of our brains’ information processing abilities, it would appear that we fall some way short of perfect performance.

One alternative possibility is that we actually gain utility not from the overall success or failure of our investing actions but from the act of realizing gains – or losses.  This was the idea behind a paper, Realization Utility, by Nicolas Barberis and Wei Xiong, who suspect that we’re more interested in how we evaluate our trades than in the total amount of money we make or lose.  They propose that we use a simple heuristic to guide us:

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“Selling a stock at a gain relative to purchase price is a good thing – it is what successful investors do”

They also suggest that another cognitive process is at work – the idea of Event Segmentation, which originated with Jeffrey Zacks and Khena Swallow.  The proposal is that we “segment ongoing activity into meaningful events”:  this affects what we remember and is, largely, an automatic process.  Perhaps the easiest analogy is to think of our brains splitting up our continuous stream of experience into a series of discrete events – in effect, we digitize our own analogue lives.

Barberis and Ziong use this idea to hypothesize the idea of “investing episodes” – a continual stream of discrete events characterized by the investment name, its purchase price and its selling price.  And out of all this we gain utility not in terms of overall wealth but in terms of the pleasure (or pain) associated with the sequence of individual experiences of profits and losses from each of our investments. 

Whether the model is actually telling us something about our internal and unconscious processing of investments is moot, but it can certainly explain a raft of puzzling behaviors.  It shows why individual investors continually sell stocks which outperform those they buy and it offers an explanation for the disposition effect. It also predicts a range of other odd but demonstrable market anomalies – the facts that highly valued stocks are heavily traded or that stocks making historical highs tend to be sold quite heavily, for instance.

This latter point is particularly interesting, because the model expects that as a stock goes through a historical high we will see an inflection point.  As the stock approaches the high there will be little selling, because those investors who would gain so-called realization utility from selling at these prices will already have done so.  But once a new high is made there will be a wave of selling from investors who have liquidation points above that price.  Which is exactly what seems to happen in the real market.

These psychological biases don’t prove that people tend to sell too soon, but the idea behind the “you can’t go bust taking a profit” meme is nastily parasitic.  A good parasite doesn't kill its host, because that tends to be a one-way ticket to oblivion.  What it actually does is siphon off enough sustenance to maintain itself and allow its host to continue to forage.  And, of course, this is exactly what the meme ensures – you can’t go bust taking a profit, but you can, and will, continue to provide the securities industry with an annuity income while ensuring that you have no chance whatsoever of growing rich.

The flip side of this, selling stocks that are losing, is equally difficult and equally valid.  But as The Babe Ruth Effect indicates many of the world’s greatest investors actually have more losing trades than winning ones.  But when they win, they win big.  But, of course, if we could all do this we’d all be filthy rich rather than simply not broke.

So here’s a challenge.  Don’t just forget about the stocks you’ve sold.  Create a portfolio of sold stocks and track their performance against the ones you’ve bought or continue to hold.  You will likely be surprised at the results.  You may also be consumed with regret and afflicted by waves of psychic pain.   This will cause you negative utility, I shouldn’t wonder.

Still, it’s all in a good cause.  No one said getting rich was going to be easy, did they?  Oh yeah, they did...   


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4 Comments on this Article show/hide all

whitmad 1st Feb 1 of 4
2

I suggest that investors should read Daniel Kahnemann "Thinking Fast and Slow" for some interesting insights in the ways instinct undermines rational behaviour.

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Paul Scott 1st Feb 2 of 4
3

Hi,

I think what you've written is very true for traders, but not so much for value investors.
If an investment of mine goes down in price, then it doesn't bother me at all, providing I am sure that I'm right about the fundamentals being attractive. It might appear a losing trade in the short term, but to me it has become a bigger opportunity, so I re-check all my analysis, then buy more.

Also, some of the richest people I know always sell first, often way too early, banking typically a 30% gain every time. Work out what 30% gains are, compounded a few times! They are recycling money into better opportunities, so their compound gain is better than what the original stock did, even when it continued rising.

Regards, Paul.

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timarr 2nd Feb 3 of 4
5

Hi Paul

I completely agree, but you are not most people and I'd venture to suggest that neither are your rich friends.

The article, as are all I write, is based on research into the habits and behaviour of average investors, not some specific high functioning subset with the time and aptitude to develop an approach which limits the impact of psychological bias and which enables them to effectively recycle and compound their gains. I would guess that the silent majority who follow what you write are more typical of the average investor than you are. And for every one who reads and learns I bet there are ten who treat your analysis as a tipsheet.

In any case, have you ever compared the cost of selling to the gains you've made by recycling? It only takes one ASOS to make an investing career ...

Love your reports btw. Quite the best thing of their kind being written by anyone.

timarr

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elizabeth_grey 11th Feb 4 of 4

I suppose it depends on what the investor's perceived risk is - I imagine that perhaps for smaller investors it's worthwhile feeling that they're not taking a big risk to get rich, as they're happy with a lower risk portfolio in general.

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About timarr

I'm a UK based technologist (career) and psychologist (academic) with a long-term interest in financial markets, with a particular emphasis (and skill) in how to not make money out of them. When I'm not working or blogging I'm to be found childminding, walking the dog or hiding in the garden shed with a good book :) more »


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