Great at buying stocks, but selling...?
ACTIVE fund managers come in for a fair bit of abuse in Money Morning, writes MoneyWeek magazine editor John Stepek in his free daily Money Morning email.
So today, I'm pleased to be able to say something rather more positive about them.
They are actually pretty good at buying stocks. The ones they pick tend to beat the market, in the short term at least.
That's the good news. The bad news?
They are absolutely atrocious at selling them.
It's often said that investors would be as well to employ a monkey to chuck darts at a list of stocks pinned to a wall, as to employ a professional fund manager to run their money.
The monkey is cheaper, and just as likely to outperform the market.
It seems that this isn't entirely true, according to a study released late last year – Selling Fast and Buying Slow: Heuristics and Trading Performance of Institutional Investors by academics and researchers Klakow Akepanidtaworn, Rick Di Mascio, Alex Imas and Lawrence Schmidt.
It's an in-depth study – it looks at more than 750 portfolios, each worth an average of a little under $600m, between the years of 2000 and 2016. So you've got a good long period, covering lots of different market conditions and millions of buying and selling decisions.
The study shows that active managers are in fact pretty good at buying stocks. New buys outperformed both the underlying market and a "counterfactual portfolio" – where the researchers randomly added the money to an existing holding instead.
The problem arises when they come to sell. If a manager sells on the back of a company announcement, then everything's fine. However, when they sold for other reasons, their performance was terrible. They literally would have been better selling a stock at random.
In other words, you should employ an active fund manager to pick stocks to buy for you. But you should then wheel in the dart-chucking monkey to make decisions about when to sell them.
This is fascinating stuff. And if I were an active manager, I'd be quite excited (and I'd make sure to read the paper). The reason that index-tracking funds have taken off is down to the belief that active managers simply can't add sufficient (if any) value to the investment process. Yet if it's possible to make market-beating buying decisions, then this clearly isn't true.
If the market is inefficient enough to allow skilled investors to outperform when they buy, then that does rather undermine some of the academic rationale for sticking with "the market" as a whole. Really, active managers only need to fix one side of the equation (their selling process) to start making the case that they really can beat the market.
I'd also be fascinated to see a breakdown of the results by fund type. Do closed-end funds (investment trusts, for example), where there is less potential pressure for "forced sales" due to clients moving money in and out of the fund, make better selling decisions than open-ended funds? It'd help to explain why investment trusts tend to have a better long-term record than other funds.
However, while this is all very well, I don't write Money Morning for active managers, I write it for private investors like me. So what can we learn from this?
The researchers are pretty clear on what the problem is – it's about paying attention. When you buy a stock, you only do so for one reason – because you think it will make a profit for you. So all of your decision-making processes are aimed at answering that one question. If it's "yes", then you buy. If it's "no" then you don't. They tend to be high-conviction decisions based on a rationale with a bit of work behind it.
But selling is harder. Once you own something, your thinking becomes befuddled for many, many reasons. It becomes much harder to approach a decision objectively.
For example, the researchers found that for active managers, the past performance of a stock played little role in the decision to buy (they clearly weren't looking at momentum funds). Yet when it comes to selling, "prior returns factor significantly...both the worst and best-performing assets in the portfolio are sold at rates more than 50% higher than assets that just under or over performed".
In other words, even professional investors have a tendency to hang on to big losers too long (sitting on a Carillion and then only selling with gritted teeth when it's lost 90% of its value), and to sell big winners too early (flogging a 100-bagger like Asos after it's doubled, for example). Meanwhile, mediocre performers sit untouched in the middle of their portfolios.
Why is this illogical? Well, think about it: when you decide to buy a stock, you do so because you reckon that its current share price does not reflect what it "should" be worth. You don't buy (or at least, if you invest on the fundamentals you don't) simply because the share price has fallen by 50% or risen by 50%.
A drastic move might have drawn your attention to the stock in the first place – that's fair to say. But the decision to buy is then based on deeper analysis from that point.
Yet selling is different. You know this yourself. Let's say you spot a stock that you really want to buy. You get excited about it. Trouble is, you have to sell something to raise funds to buy it. So you take a look at your portfolio.
You have a stock in there that has gone down by 25%. Ouch. Thinking about that makes you feel uncomfortable, so rather than dig into whether you should still be holding onto that one, your eyes smoothly gloss over that line in your broker statement.
Instead, you focus on the lovely, well-behaved stock that has doubled since you bought it six months ago, proving your investment genius. You grin, then take a cursory glance at the chart for that one. It hasn't done much for about a month now. And it's given you a good turn, profit-wise. Can it really go up much more? Ah, probably not. And why be greedy?
So you sell out to raise funds for your new purchase. You don't feel the pain of crystallising a 25% loss on the other stock. And you make a mental note to never look at the share price of the stock you just sold, in order to avoid future pangs of regret.
So you never find out that the stock you sold went on to do rather better than the one you replaced it with, and an awful lot better than the loser that you held onto in its place. And so you never learn from your mistakes. That's a pretty high price to pay just to be protected from cognitive dissonance.
What's the solution? You have to treat selling decisions in the same way as buying decisions. And I still think that the easiest way to do this is to make sure that you write down your reasons for buying in an investment journal before you make a purchase.
That way, you can look back and get a clear view of why you bought in the first place, unblemished by subsequent moves in the share price. You can then make an informed selling decision: if the share has met your goals, you can reassess, and if nothing has changed, sell. Or if your buying rationale has turned out to be wrong, you can reassess and sell.
But if you'd still buy the share at the current price and in the current circumstances, then why sell? (By the way, I talk about all of this a lot more in my forthcoming book, The Sceptical Investor, which I'll be plugging shamelessly over the next few weeks.)
I'm not saying you won't miss out on 100-baggers, or end up hanging onto duds. But you should do it a lot less often than if you simply trust your instincts. Going with your gut is right in a lot of situations – but when it comes to investing, it's better to assume that it's always wrong.