Quantitative Tool Helps Managers Sell
Bearing Up in a Bear Market
April 27, 2009
The 19th Century London financier Nathan Rothschild is credited with having said, "The time to buy is when blood is running in the streets."
As this maxim suggests, market turmoil can present equity managers with extraordinary buying opportunities. Capitalizing on such buying opportunities, however, generally requires managers to create liquidity within their portfolios-and that means knowing what to sell. Selling is prone to behavioral influences. Research suggests that behaviorally motivated sell decisions increase when experiencing under-performance or riding out a turbulent market. There are ideas to help check behavioral tendencies during these kinds of turbulent times.
Firstly, question yesterday's answers. No one likes being wrong, particularly publicly. Holding on to positions with unrealized losses can be encouraged unintentionally by maintaining a "full value" price for a stock based on old or faulty information. Anchoring, as this tendency is known, can be exhibited by either analysts, managers or both. Challenging yesterday's assumptions and conclusions can help.
Remember, no pain, no gain. Managers sometimes engage in elaborate self-deceptions to maintain losing positions in the portfolio. The most common rationalization for holding onto losers involves the expectation for a near-term rebound. Loss aversion, a behavior known to stifle the selling of losers, stems from our desire to avoid locking in a loss and subsequently feeling bad about our decision to own the stock in the first place. Extensive research performed by Cabot Research indicates that professional managers often fall into the trap of loss aversion-at least with regards to certain positions-and that correcting this behavior can lead to significant improvement in performance.
Also, managers need to safeguard against the desire to reconstitute the portfolio and place all the bad news behind them precipitously. On the surface, this approach can seem entirely economically motivated. The familiar mantra of, "If you wouldn't buy it today at today's price then you should be a seller," comes to mind as a strong defense for "clearing the decks."
Overreaction when below the benchmark, however, is a well-documented behavior. It reflects elements of prospect theory, wherein people prefer to swallow all their bad news at once, while savoring their good news in little bites-for emotional rather than economic reasons. Maintaining your cool under siege and carefully reevaluating each position in the portfolio can go a long way towards avoiding this type of costly over reaction.
Selling is often backward looking, requiring a rear-view mirror, in that past performance influences which positions are sold and which are held. Overcoming the strong desire to sell a position that is down significantly-regardless of its future prospects-is part of what separates a careful sell discipline from "rules-of-thumb." Marketing demands can conspire to accentuate unconscious perceptions about a stock.
This can lead to holding recent winners too long, so that they can be discussed with prospects as representative holdings, or jettisoning recent losers so they don't have to be discussed. Whether guarding against holding on to "show dogs" or engaging in "window dressing," managers need to exercise added vigilance in evaluating their sells in today's raucous market.
Good experiences can lead to poor learning. It is from the careful analysis of our experiences-and not merely having had those experiences-that the most important lessons are learned. In their paper, "Once Burned, Twice Shy: How Naïve Learning and Counterfactuals Affect the Repurchase of Stocks Previously Sold" (Working Paper, September 2004), Terrence Odean, Michael Strahilevitz and Brad Barber describe that investors may avoid specific stocks simply because they previously sold them for a loss.
In these instances, investors appear confused between price volatility and fundamentals or their earlier judgments and the go-forward prospects for the stock. Such inappropriate lessons are referred to as counterfactuals and can easily exist when a manager's reflections about events go uncalibrated. The challenge for managers is to learn the correct lessons from experience, and this usually requires both (1.) the perspective gained from time coupled, with (2.) an objective, analytical review of what really happened.
Consequently, a wrenching market may not be the right environment in which to refine your strategy.
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