August 18, 2009

When to sell ?

I recently received a comment from rajiv which is reproduced below


As a stock moves towards its intrinsic value, there is a temptation to exit a little before the final value is hit, especially if you have waited a long time for Mr. Market to come around.
I feel that as a value investor the sell decision is much tougher than the buy decision, because the buy decision usually comes with a big enough margin of safety. However, during the sale decision the market value may be stuck at Intrinsic Value minus 10%, making the investor quite jittery to sell.

I have been asked this question in a several different ways, but all essentially boil down to the point – when should one sell a stock ?

I agree with the point made by rajiv and several other readers – selling is more diffcult than buying. In addition, there is no clear cut formulae for selling. The process of selling is made even more diffcult by the various emotional and psychological factors involved in selling.

Emotional factors
Most the discussions and articles on investing rarely discuss emotions explicitly. I find that strange as anyone who has ever invested in the market can vouch for the emotional roller coaster. The rational aspect of selling is easy for a long term investor – sell when price crosses intrinsic value (or 10% below or above – take your pick of the number)

I have written on the above question earlier – see
here. The is the rational way of deciding on when to sell.

Now this suggestion may have sounded irritating to some of you and rightly so. The reason this advice, though rational, does not sound great is due to the emotions involved in selling.

There are two situations in which one is selling – one has made great gains in the stock and wants to capture some of the gains. Selling at this point is driven by the fear of losing the gain, which is counterbalanced by the desire to hold on to a stock which has treated you well and also by the doubt that there may be more upside to it.

The other situation in which one sells a stock is when one has lost money on the stock and wants to get rid of that piece of !!@##. In this situation the decision is driven by disgust.

These emotions are quite powerful and not easy to manage

Ok, dude then what?
All these emotions are nothing new, right ? Even if you have felt these emotions earlier, it does not mean that you are managing them well.

A few of the readers and my friends have mentioned to me that I seem rational and cool headed. I wish !!. I am no different, atleast in most aspects. In case of investing, I have tried to manage my emotions as much as I can (manage and not master).

I maintain a spreadsheet of all my holding with the qty, intrinsic value estimate, current price and discount to the current price. At any point of time, when I am looking at my holding, I am looking at the instrinsic value and the discount to it. I ‘anchor’ myself to the instrinsic value. As a result if the stock is selling below the intrinsic value, I will continue to hold.

As the intrinsic value of the stock gets updated every quarter, I am not tied to a fixed value. If the business performs well, the intrinsic value goes up and so does the sell target. If the company performs badly, then the reverse happens.

So is this buy and hold ?
Buy and hold is most abused and misunderstood term (more on that in another post). My approach is not buy and hold, tops and bottom or any other term or title. The logic is simple – buy when something sells for less than intrinsic value, hold till it is below intrinsic value and sell when it is above it. Now if the intrinsic value grows faster than the price, I will continue to hold.

Where’s the catch ?
The catch is in getting the fundamentals and intrinsic value estimate wrong. If you get that wrong and refuse to change your opinion, then you are toast.

But you lose money when the market drops !!
Yes, that does happen. If the market drops, my portfolio will drop with the market. I have yet to figure out how to keep jumping in and out of stocks and still keep my sanity. There is so much chatter and noise in the market, that it is easy to go nuts. My way of keeping my sanity intact, has been to adopt the above approach.

Is this the best way ? no I will not claim that. However as I have a day job, I would rather lose a percentage points, than lose my job and maybe my sanity. Finally, I have yet to find another approach which relies on a sensible and consistent logic and not on the opinion of others.


Anonymous said...


Aniruddha said...

Daniel Kahnerman and Amos Tversky carried out experiments in the late 1970's that go a long way to explain our instincts to sell our winners and hold on to our losers.

They carried out experiments in which people were questioned about their preferences. Here are two questions, similar to those asked by Kahnerman and Tversky. Try answering them yourself:

Q1. You are offered a choice between two outcomes:

A. You have an 80% percent chance of winning $4,000 with a 20% chance of winning nothing.


B. You have a 100% chance of winning $3,000.

Which of these would you choose? Make a choice before answering Q2.

Q2. You are offered a choice between two outcomes:

A. You have an 80% chance of losing $4,000 and a 20% chance losing nothing.


B. You have a 100% chance of losing $3,000.

Which of these would you choose?

It turns out that the vast majority of people choose outcome B in question 1 and outcome A in question 2. In other words:

* When we are winning we prefer to choose certainty.

* When we are losing we prefer to gamble.

These are our basic human instincts.

If your gut instinct was to answer A to Question 1 and B to Question 2, you may have the instincts of a successful stock trader. Your instinct is to gamble when you are winning - in other words let your profits run - and to choose certainty - in the form of a definite limit on your losses - when you are losing - in other words cut your losses.

After carrying out a number of experiments, Kahnerman and Tversky concluded that people are naturally averse to losing and are more willing to gamble their way out of a losing position than to gamble in a winning position

Aniruddha said...

There is an old saying that says, "any fool can fly, but it takes an expert to land".

Applied to stocks, we say, "any fool can buy but it takes an expert to sell".

Ninad Kunder said...

Hi Aniruddha

What u have stated is a good example of the " Loss Aversion" behavioural trait.

I think the key is to look at the payoff of every investment at every stage. Like in the example u stated the payoff in both the examples is 3200 versus 3000.

So the sell decision falls in place if u believe that the payoff turns negative at a point in the price of the stock.



Joe said...

Rohit - I posted this message a couple of days ago and not sure if it got to you.

Have you considered studying Value Investing formally either at Columbia or with some Value Investing Mentor? If not, why? Do you have any thoughts about the program at Columbia? Are there alternatives to studying this discipline outside of India? I guess this question is to all who read this blog.


Rohit Chauhan said...

Hi anonymous

the spreadsheet is a simple tabulation as i mentioned earlier. will post it soon


Rohit Chauhan said...

Hi anirudha/ ninad
loss aversion is now a known concept - atleast some investors know the bias.
It is not easy to overcome, but as charlie munger has said it - one needs to train oneself to think in terms of probabilities when investing.
i would say that one should think in terms of probabilties in other areas too. this is ofcourse quite diffcult to do in practise.
one book on this is by robert rubin who was the treasury secretary with clinton.


Rohit Chauhan said...

Hi joe
unfortunately i did not get this comment.

I have always wanted to study value investing at columbia or under a mentor. As a far as columbia is concerned, it is beyond my financial reach india, prof bakshi teaches a course in the MDI institute. i would love to attend that course, but it is part of a full time program which will not make sense for me.

this course by prof bakshi is great course. there are several readers who are his ex-student and they can provide more details


Sachin Purohit said...

The real problem lies in the fact that what we call as the Intrinsic Value is in fact perceived Intrinsic value. Unlike the bonds where future cashflows are certain (unless there is a default risk), what we have in case of shares is just our estimates of future cashflows. The real intrinsic value is known only after we see our estimates coming out true. A small deviation from estimates will make a sharp difference in our estimate of the current value of those future cashflows. So a 10% less than the perceived Intrinsic Value may as well mean the real intrinsic value has already been surpassed and the stock may have moved towards overvaluation side. Margin Of Safety for selling as well?

Rohit Chauhan said...

Hi sachin
you are right.intrinsic value calculations are an estimate ..they are not cast in stone. one can arrive any value one wants, the devil lies in the assumptions one makes.

as a result one has to be conservative in calculating the intrinsic value.

in addition, if you have noticed i do a probabilisitic exercise of calculating the intrinsic value ..a pessimistic case, an as is case and an optimistic case. in addition i will use other approaches also to value the stock ..if all are in a tight range ..then you can sure that the estimation is good.

keeping a margin of safety in selling is not bad idea is acknowledging the limits of ones knowldege

no matter how quantitative we make it, investing is an art and numbers can take you only so far


Things to remember while selling

1. Why did i buy? - Always hold until the reason for your buying is a valid.Don't sell just because you are making a good profit.

2. Why to sell ?- All investors would like to buy at the bottom and sell at top however its impossible to call a top. So I typically have a value range, this range is determined using multi disciplinary approach like DCF, mcap of similar businesses, historical PE range for the market and the historical PE of the sector. Having determined the range i think terms of probabilities.

3. Maturity cycle - All businesses have a maturity cycle, nothing grows to infinity. At what point is your company?

4. How much to sell -Once you have made-up a mind to sell, do it completely.

5. What if stock goes up - Stocks go up and down for a various reasons. Many times stock may go up as soon as you sell but accept that and move on. You may be proven right in a couple of days