This is why you don't sell your winners

January 16 [Thu], 2014, 17:20

This is why you don't sell your winners

When it comes to investing, there's no shortage of bad advice floating around out there. Among the worst, though, is the old saw, "You can't go broke by taking a profit."

The saying refers to the belief that if you have astockthat's gone up in value, it's hard to go wrong selling that stock and "locking in" the gains. But while the saying is technically true it's hard to picture a scenario where an investor is suddenly bankrupt after selling a stock at a profit it's a dangerous platitude for investors to follow.

The practice of selling winningstocksand hanging on to losing ones is a practice that's familiar to behavioralfinance experts. It's a behavioral bias known as the disposition effect and has been revealed to be quite harmful for investors. A number of academic papers have shed light on the subject, including Berkeley professor Terrance Odean's 1998 study that concluded thatindividualinvestors' "preference for selling winners and holding losers leads, in fact, to lower returns."

If the longterm returns from stocks were distributed normally that is, they formed the familiar bellshaped curve and most stocks' returns clustered around the average selling winners and holding losers might actually work. If the returns from mostindividual stockswere likely to be right around the average for all stocks, then a big winner would be more likely to stall out after its winning streak than continue climbing. At the other end, it wouldn't be unreasonable to expect a stock that's been a big loser to climb back closer to the average.

I was reminded of this by a recent report by Shankar Vedantam for nike air max NPR, called "Put Away the Bell Curve: Most of Us Aren't 'Average.'" Vedantam reviewed the research and work of Ernest O'Boyle Jr. and Herman Aguinis, who studied the performance of 633,263 people involved in academia, sports, politics, and entertainment.

In short, the pair's finding was that the performancedistributionin these groups wasn't bellshaped. Instead, many participants clustered below the mathematical average, while a group of superstars produced results far above the average and pulled the overall average up.

Stock returnshave a similar distaste for fitting to abell curve. Over the past 10 years, 63% of the US S 500 companies underperformed the average. Meanwhile, a large group of significant outperformers delivered returns that were well above the average.

As compared with the bell curve in the background, the data plotted here is a mess. And it should be. Stock returns are not normally distributed which is what produces that nice bellshaped curve. And though statsstars who are much smarter than me often try to describe stock returns as "lognormal" a mathematical transformation of the returns that gets them to more closely fit a bell curve they're not that, either. Stocks are typified by "fat tails" on either end that is, more seriously outperforming and underperforming stocks than is easily captured by streamlined mathematical models.

So no matter how you look at stock returns, a surprising number of stocks end up returning far more and far less than the average. Practically, this means that the practice of "locking in gains" and hanging on to losers is a good way to miss out on the market's huge outperformers, stay stuck with poor performers, and earn lacklustre overall returns.

The next question for many stockpickers is this: How do I know which winners to hold on to? If nike free run there was an easy answer, then we'd all be Warren Buffett. But here are three important points that are underscored by the returns from the S stocks over the past decade. For years, many investors looked atApple's (Nasdaq:AAPL) stock and avoided it because the stock had gone up so much. The company kept right on growing, though, and that growth backed up the stock's tear. As of today, it's the S top performer over the past decade. But that huge gain means little when considering whether Apple's stock will go up or down from here it matters far more what thebusinessdoes in the future. Among the S very best performers over the past decade areCaterpillar(NYSE:CAT) andNike(NYSE:NKE) both older companies intraditionalbusinesses that simply do what they do better than their competitors. And the fact that both companies continue to perform well suggests that there's still no reason to abandon solid businesses like these today. As much as I lovedividends, that metric alone may have hurt more than it helped over the past decade. At the outset of the 10year period (2002), five of the top 10 performing S stocks paid a dividend. Meanwhile,nineof the 10 worstperforming stocks paid adividend. Focusing on one industry wouldn't have been much better, since basically all of the major industries were represented among the top and bottom performers.

While it may seem thatequity investinglacks easy answers, there actually are two. One is to not bother trying to find the market's super stocks at all and instead just capturing the market's performance as a whole by buying a lowcost index. The other is to quit relying on simplisticstock marketsayings and rules of thumb and instead get your hands dirty researching and learning about the companies you're investing in.

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