Selling winners and holding losers - even the smartest investors get it wrong

Thursday, Nov 26 2015 by
Selling winners and holding losers  even the smartest investors get it wrong

The study of how human instinct impacts on investment decisions is hotly debated and sometimes controversial. But even Ben Graham, the father of value investing, was aware of the potential for investors to err. He famously warned that “the investor's chief problem - and even his worst enemy - is likely to be himself.”

One of the best known behavioural trap-doors is to hang onto losing investments for too long and sell winning positions too soon. It’s a phenomenon known as the Disposition Effect. For years, researchers have warned that investors can damage returns by cutting winners and riding losers. Often, this warning has been pitched in the direction of relatively unsophisticated retail investors. But new research suggests that the same behavioural flaw exists in some of the market’s smartest and best informed traders - Short Sellers.

It serves as a reminder that the risk of succumbing to selling the wrong positions is something every investor needs to be aware of. So here’s a review of how things can go wrong and why smart investors are susceptible too.

Why we sell the wrong shares

If you were looking at a map of behavioural finance, you’d arrive at the Disposition Effect directly from two other places: prospect theory and mental accounting. These are theories about how humans make choices between risky prospects and how they categorise them based on different outcomes.

In the context of investing, these theories claim that investors treat the probability of a loss differently to that of a gain. With the Disposition Effect, what this means is that investors irrationally sell winners and hold losers even though it often makes no economic sense.

Some of the best research into the consequences of all this was done by Terrance Odean, who waded through 10,000 accounts held at an American discount broker between 1987 and 1993. He found a clear tendency for investors to sell winning positions over losing positions. Moreover there was no good reason for it - there was no evidence that these investors were deliberately rebalancing their portfolios. On average, after one year, the losing stock, that was held, fell by 1.0% against the market. While the winning stock, that was sold, actually gained 2.4% above the market.

Momentum rides on the Disposition Effect

Clearly, Odean’s findings show that the Disposition Effect can damage performance - but not everyone loses. Readers…

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As per our Terms of Use, Stockopedia is a financial news & data site, discussion forum and content aggregator. Our site should be used for educational & informational purposes only. We do not provide investment advice, recommendations or views as to whether an investment or strategy is suited to the investment needs of a specific individual. You should make your own decisions and seek independent professional advice before doing so. Remember: Shares can go down as well as up. Past performance is not a guide to future performance & investors may not get back the amount invested.

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16 Comments on this Article show/hide all

herbie47 26th Nov '15 1 of 16

Yes most of us are guilty of selling too early. But little is talked but selling too late, many companies have fallen back recently, there have been many profit warnings, even on high rank Stockopedia companies. Decision of when to sell is difficult. Also you can sell losers too early before they have had a change to recover. I keep a watchlist of my sold shares, this year its -12%, so selling has benefited me, yes I got some wrong, housebuilders I sold some before the election as I did not expect the Tories to win, another other one was Xchanging (LON:XCH) which had a takeover bid after I sold. In this market I'm inclined to take profits.

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davidtalbo 26th Nov '15 2 of 16

Hello Ben

Another excellent, informative article.

Most research suggests, as you do above, that for better investment performance one should run the winners and sell the losers. Equally, however, a lot of research suggests that, for better investment performance, one should periodically re-balance portfolios, which effectively means selling (in part) the winners and topping up the losers. Any thoughts on this apparent contradiction?

David Talbot

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purpleski 26th Nov '15 3 of 16

Of course there is the other side to this which is that once you have bought into a sound company, that you hold for ever. (I am not talking about short term trading in the latest hot stock or the latest blue skips company or some uber speculative stock).

This is what entrepreneurs do when the start a business (that survives). They start a business and then stick with it through all (to use on of Ben Graham's lovely use of the English language) vicissitudes of the economy. I have done this with my own very small company where 25 years on turnover is 30 times what it was in year one. These are certainly the sort of companies I am looking for.

Then there is the research by fidelity that found their best performing accounts were those of people who had either died or had forgotten that they had a fidelity account.

It is certainly the philosophy that I am tending towards and though I currently have 38 stocks in my portfolio half of it is in about 10 stocks. I know that this concentrated portfolio style is generally frowned upon but if my business was part of my portfolio it would represent 92% of my portfolio. I am comfortable with that.

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cig 26th Nov '15 4 of 16

In reply to davidtalbo, post #2

"Running winners selling losers" is just a somewhat oddball way to say momentum is your friend. Re-balancing is saying diversification is good for you. No contradiction here, indeed both strategies complement each other nicely (smoothed momentum).

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davidtalbo 27th Nov '15 5 of 16

In reply to cig, post #4

I agree re-balancing produces a more diversified portfolio, but that was not my query. There is research that suggests that re-balancing a portfolio produces better returns and that appears counter intuitive to the (stronger?) research that suggests you should run your winners and cut your losers.

David Talbot

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timarr 27th Nov '15 6 of 16

Barber and Odean's research indicated that the shares that people sold went on to outperform the ones that they bought - suggesting that their decision making was biased, probably by loss aversion - people don't like to take a loss, so sell winners (to lock in the gain) and keep losers (to avoid realising a loss). That's acting counter to momentum effects but it's also likely to mean that investors dump stocks with good fundamental characteristics purely because of an arbitrary gain anchored on a more or less accidental buying price.

Generally running winners and dumping losers works with momentum but, on average, it's also likely to work with GARP type stocks as well: you'd expect companies with defensive moats like Coca Cola or Unilever to carry on churning out decent earnings improvements for a long time into the future - so if you can buy them at a reasonable price it makes very little sense to then dump them for a small gain. Equally running losers is also a poor strategy - momentum effects tend to mean revert over three years, so a losing investment can carry on losing for quite a while.

Rebalancing should work as long as it's not done too frequently, because you capture the mean reversion effect of momentum - selling gradually as shares rise and buying into them as they fall. However, the point about rebalancing in this context is that it's mechanical, so it removes the human factor from the decision making process. Selling and buying because of the disposition effect is on average a losing trade while selling and buying because of rebalancing is on average a winning trade.

The difference is caused by the unfortunate fact that the average investor's decision making contributes negative value to their portfolio - hence the Fidelity research mentioned by purpleski, that investors who had forgotten they had an account (or had died) outperformed those that actively traded. Although (as far as I can recall) I don't think Fidelity ever published the details of the underlying data.

But basically most of us would perform better by buying some half decent stocks or an index tracker or two and then leaving well alone.


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Warranstar 29th Nov '15 7 of 16

So would a good rule based approach to this be to only consider selling your winners when the Momentum rank drops below 50?

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herbie47 29th Nov '15 8 of 16

The problem I have found with smaller companies winners often become losers, see Solid State (LON:SOLI), Amino Technologies (LON:AMO), Vislink (LON:VLK), Dialight (LON:DIA), Clarkson (LON:CKN), Stanley Gibbons (LON:SGI), Entu (UK) (LON:ENTU), Porta Communications (LON:PTCM)

Then what do you do? Take Solid State (LON:SOLI) it was around 850p before falling to 380p and within 10 days its back up to 590p, someone on here advised me to sell at 400p. With hindsight of course you should have sold at 850p and bought back under 400p. Maybe a 20% stop loss from the highest price is a good idea?

I think momentum below 50 is too late.

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Mark Carter 29th Nov '15 9 of 16

Maybe tiddlers like SGI and VLK are too volatile for things like momentum strategies to work. I think you need to pull in the crowd gradually, which won't happen with the micro-caps.

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herbie47 29th Nov '15 10 of 16

In reply to Mark Carter, post #9

SGI was about £150m at start of 2015, so was larger than some of the others.

I just think when momentum drops or even slows its the time to sell. I sold VLK near its 52 week high and many others. But have found it difficult to make gains lately. Even the Stockopedia picks are not making any gains, in fact 50% are slowing a loss. I think Ed's SNAPS bear this out with only a 1% gain in last 5 months. My own NAP selection is up 3% since June.

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Mark Carter 29th Nov '15 11 of 16

In reply to herbie47, post #10

Don't forget though that the All-Share is down 5% in the last 5 months. So the SNAPS are ahead 6%. Extrapolating that to a year - dangerous, I know - that's actually pretty good. It may not be indicative, but if you can come out 10% better than the market, then that's a roaring success.

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herbie47 29th Nov '15 12 of 16

In reply to Mark Carter, post #11

Yes that is true, however the FTSE Allshare and FTSE100 indexes has not performed well for the last 5 years, about 20%. The FTSE250 and SmallCap have performed much better about 50%. If you are only going to make about 4% a year then I don't see the point in taking the risk.

Some decent UK small company funds are up around 120% over last 5 years.

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ed_miller 30th Nov '15 13 of 16

In reply to cig, post #4

Just to note that "running winners and selling losers" need not refer, necessarily, to share-price momentum - long-term fundamental investors might instead apply that test to operational performance, being content that the share price will eventually catch up so long as operationally the company continues to make progress, and so long as the share does not become grossly over-valued.

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justinian 30th Nov '15 14 of 16

The approach taken depends on one's aims. I get the feeling that a lot of investors are subconsciously prepared to underperform the market as long as they can have reasonable certainty that their money will not disappear in the time that they need to call upon it. In which case lots of little 'losses' and underperforming the market may well be a price worth accepting.

There are other pieces of research related to this area that shows on the whole that operating a stop loss system will lose one money over the long run.

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bargainvalue 21st Dec '15 15 of 16

I think, that a "system" can be helpful. If we set ourselves boundries (e.g. we sell when the stock will lose more than 10%, because it is the limit I can afford), it is possible to reduce the number of wrong decisions or feel more comfortable with them at least. Human nature has got a lot of disadvantages and it is impossible to control all of them. For example, the the choice supportive effect, about which I have written. Relying on the one or few "facts", that we WANT to find is not logical, but we do it anyway. Moreover, we exaggerate the meaning of them, because we want to be right. The cold, analytical attitiude is possible only, if you don't put your money in this game. 

Blog: Bargain Value
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herbie47 22nd Dec '15 16 of 16

In reply to bargainvalue, post #15

10% is too small a drop to be selling at, most shares even in FTSE100 move by more than 10% , systems can be helpful I agree but 10% trailing stop loss would not work for most shares, as you would be out within a short time. 15-20% would be better but I think it depends on the share. I find value and momentum is quite a good way of judging when to sell but does not always work, for example some shares have a rest for around 6 months before climbing up, you need to check RNS to see what is happening. But then if you are out and into something else that is moving up then its ok. Stockopedia is good at giving an indication about value and momentum, although I don't always agree with some of there figures, why is Inland Homes (LON:INL) value 76? , PE(f) is 14, PEG is -, PBV is 1.98, PTBV 1.98, PE 14, EPS 2016 is -59. Ive looked at other shares with better figures and they have lower value rank.

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About Ben Hobson

Ben Hobson

Strategies Editor at Stockopedia. My goal is to help private investors learn and invest with confidence through the articles, ebooks and other resources we publish on site. I also occasionally bunk off to interview famous investors at expensive restaurants. I studied History at Aberystwyth University, trained as a journalist and covered business news and corporate finance before settling in as one of the first staff members at Stockopedia.  Away from Stockopedia I'm a mountain bike junkie. more »


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