How Investment Pitfalls Impact Selling Decisions

The investment industry is designed to create activity- buying or selling and never staying put. And at times, it's very important not to act; that's the best action, which the financial media hardly ever allows. It's very difficult to remain stoic and do nothing when everyone around you is doing something. This is particularly true when it comes to selling. The itch to act is high when the narrative and news flow are against the company.

A research paper by Frank Thormann in 2022 shows how human decision-making is beset with frequent behavioral biases, leading to poor financial decisions. The paper is aptly titled, "Why Most Investors Are Bad at Selling and what they could do about it." The paper refers to an analysis by the Financial Times showing that only about one in four professional portfolio managers investing in the US managed to beat S&P 500 in 2021.

When one further analyses the actions for this poor performance i.e., how much is attributed to their buying decisions compared to their selling decisions, the results are astounding. The aggregate buying decisions added 1.4 per cent of outperformance per year while selling decisions detracted a negative 1.8 per cent annually in underperformance.

This demonstrates that the majority of the fund managers do actually have a persistent skill in selecting investment opportunities that outperform following the buy decision. However, aggregate results are poor because investors managed to lose staggering amounts of money with their ill-timed selling decisions.

Modern brain studies have shown that the emotion of fear is processed very differently in the brain from that of the opposite feeling of exuberance because it is processed in a different location of the brain. As a result, humans think of (financial) losses very differently to how they think about gains, leading to suboptimal decision-making.

The paper concludes that selling is a neglected skill and little attention is given to a large problem. He points to various behavioral biases that could be the source of these causes. Loss aversion: This is the tendency to allow very recent performance history to shape one's risk assessment of an investment. For instance, if an investment has recently declined in value and is now carried at a loss, this loss triggers a fear response in the investor's brain, which in turn leads them to conclude that the investment is much riskier than a comparable investment carried at a gain. This natural fear of realising a loss forces fund managers/investors to hold onto a losing position much longer than is rationally warranted.

The remedy is to have a strategic asset allocation and rebalancing formula. An action plan on how to react to defined scenarios. A framework to automatically review money-losing positions with an explicit emphasis on the future investment prospects.

Availability bias: In complex decision-making, humans do not consider all alternatives equally but quickly latch up on to the ones which come to mind first. Prof. Jin and Taffler have illustrated this by point by separating all portfolio manager decisions into two categories: first, those motivated by new money inflows or outflows (liquidity events), and second those driven by relative risk/reward assessments. The results were astounding. When dealing with liquidity events, fund managers' selling decisions were particularly poor.

To address this bias, investors should always question their premise irrespective of the motivation to sell. Which stock in the portfolio has the worst risk/reward in the period to come?

Confirmation bias: Optimism is good in many aspects of life but not during rational decision-making. Once an investment decision is made, we are bought into its merits and are committed to it. Unfortunately, this clouds our judgment to interpret the subsequent data points in a way to appear favorable to our original premise. This bias makes it highly likely that we miss important information that runs counter to our beliefs.

Overcoming confirmation bias could be done by employing a neutral observer picking up negative data points. Or play a devil's advocate by explicitly focusing on what data would look like should things go wrong.

Spending more time on buying decision than selling: Countless hours are spent analysing, preparing lengthy reports, extensive modelling and intense discussions in the buying process while most of the sell decisions are often much faster. As a process investors should expend more meaningful time towards sell decisions too.

Cognitive biases affect not just investing but all realms of life. So, to reduce falling prey to these, investors must maintain a journal to keep track of the rationale, emotions, data for each of their decisions while also employing these remedies.

(The author is a partner at 'Wealocity Analytics', a SEBI-registered research analyst firm, and could be reached at [email protected])