When we think about investing, we always think about buying. We spend enormous amounts of time forecasting the future, distilling vast stores of information into one single click of a green button. But what is commonly overlooked, is the other side of the equation - selling. It remains the poor cousin of buying, yet it shouldn’t be. Selling is as important to investing as braking is to driving. Selling at the right time is just as important as timing on the entry. Yet all too often, investors only know the accelerator and gloss over the analytical framework of selling. In doing so, they give up much of the hard work they have put in to establish the buy thesis.

In this publication I will share my insights from the perspective of a global equities investor who has made misjudgements when selling and what I’ve learned from the mistakes of others and my own.

Why are institutional investors so bad at selling?

It may surprise you to know institutional investors do not have an edge when it comes to selling. Recent researchers studied the outcomes of selling decisions and determined there was substantial underperformance over the long-term. So bad were the selling decisions they even failed to beat a random selling strategy. These weren’t retail investors. The study looked at portfolio managers with an average USD $600 million size. The outcome? They still failed to outperform a simple randomised strategy.

But why are institutions so bad at selling?

Poor selling hurts returns more than you think

Without an analytical framework for selling, investors use mental shortcuts which are susceptible to behavioural biases and lead to inconsistent results. Poor selling can hurt you in two ways. First, you can sell out of a great company too early. The seed of a Californian redwood tree is only a tiny speck yet it has great potential beyond its appearance. Dispose of those seeds and you end up missing out on a giant.

Second, a weakness in your selling process can lead to prolonging a losing investment far too long. Our cognitive biases can shroud our judgement. We can become committed to a previous decision and fail to see how changing circumstances no longer make an investment worthy of our portfolios.

The psychology of selling

Inspecting my own game, I came to realise the importance of a strong short game to complement my long game. By ‘short’ I mean selling stocks you own, not short selling (which is selling what you don’t own). Most fund managers only focus on their long game and disregard the short (I suspect this is also true of their golf). The research supports this. Professional investors are able to outperform through stock selection and buying, but many underperform when it comes to selling decisions.

But why? Buying and selling are simply two sides of the same coin. If one can make good buying decisions, why does it differ so much when it comes to selling?

Use heuristics with caution

Recall earlier I introduced the term ‘mental shortcuts’. In psychology, these are known as heuristics. They’re good for simple decision making, but detrimental when it comes to complex analysis required in investing. Without a system of thought when selling, we gravitate back towards a structureless approach. And this is where it can go wrong for many investors. Even at the institutional level, cognitive biases creep in. Research found the most common being:

• The disposition effect: a reluctance towards selling losers, and inclination to selling winners.
• Overconfidence: assuming you will make the right decision to sell without any factual analysis.
• Narrow bracketing: looking at decisions in isolation without consideration for the broader picture. Analysts who focus on one geographic or sector are most susceptible to this.

This makes sense. Most institutional investors spend less time thinking about their selling framework, they are measured for their efforts in buying. Incentives are centred around investment prowess, not divestment skill. I've written previously about how enterprising investors can outmanoeuvre institutional investors here.

Easy come, easy go

From my own experience, I deploy more capital to those investments that I have greater conviction in. The greater weighting reflects my analysis and the velocity which I think returns can be made. This conviction when entering a stock also translates to better selling performance on exit. Another takeaway from the study shows poor selling decisions tie closely with low conviction investing. Just think about those stocks representing the smallest proportion of your portfolio. These are the stocks you are most likely to make bad sell decisions with.

Knee-jerks that hurt

One of the main reasons institutional investors make bad selling decisions is because they react to price movements. All the fundamental analysis done when deciding to buy is not mirrored when they sell. Instead, sell decisions are either automatically triggered via stop losses or to capture recent gains. Either way, basing selling decisions purely on price is what leads to underperformance. To counter a pure price focus, the questions investors should focus on are:

Have business prospects fundamentally changed for the future?

Are customers migrating away from this industry?

Does the company still retain its competitive edge?

It’s that time of year

Following closely behind automated selling strategies are the financial calendar trades which occur when professional fund managers decide to sell for no other reason than to realise taxable losses or crystalise their gains as they massage their financial year end results. Annual bonuses drive selling decisions which are proven to underperform in the long-term. From the portfolio manager’s perspective, it may not matter if they are rewarded for these decisions so long as they achieve their end of financial year KPIs.

Knowing these weaknesses is one thing, mitigating them is another. It is only once these issues become known that addressing them becomes possible.

Incentives that create value

The single hardest and simplest correction for most investors is to align your long-term incentives with your selling strategy. If your investment strategy is long-term and you want to compound your investments, then set up a framework that rewards careful, fundamental analysis before selling. I've written about this previously here. The same questions when buying should be applied to selling. Here is where private investors have an in-built advantage over institutions - they innately possess the flexibility and natural incentive to perform over the long-term; ignore the arbitrary financial year end distractions and focus on the real fundamentals.

Institutional managers need to think as if they are the largest investor in their fund.

Investing with conviction matters

Dipping toes in waters is not the optimal way to invest. Concentration leads to outperformance as it encourages deeper analysis. Nothing like a big investment to ward off capriciousness. The benefit isn’t only on the buy side. The research shows selling decisions benefit too when concentration is higher. Invest mindfully and with meaning. Underperformance happens when you’re selling out of a stock you were never that convinced with in the beginning. Easy come, easy go, but you will pay for it when you sell.

Stress and other suboptimal influences

Have business prospects fundamentally changed for the future?

Are customers migrating away from this industry?

Does the company still retain its competitive edge?

The answers to these questions will inform whether you hold or sell.

But as we have seen recently, when you’re facing a 30-40% drop in prices, the stomach will take over the mind. Stress sets in, sometimes even panic. This pressure is even greater for institutions who have to report back to thousands of clients. They become price-reactionary. Heuristics to invade the decision-making process when time is pressured. Evidence points to the most severe underperformance on sales coming after extreme price movements. Institutional investors are susceptible to mental shortcuts as they tend to use stop-losses, automatic rebalancing to benchmark weighting, and auto profit-taking triggers to simplify sell decisions.

Sell because of changes in business prospects, not because of stock price movements, even if you’re under extreme market pressure.

How to use feedback

Institutions spend less time analysing the selling decision. They will meticulously track buying decisions, but they rarely analyse how selling decisions went. A technique I employ to improve selling decisions is to elucidate myself with iterative feedback. Track the results of selling decisions just as you would with buying decisions. Each iteration of feedback informs how a sell decision can be improved for next time. Without it, investors are blind to their own mistakes.

The dangers of commitment bias

Cognitive biases cloud our judgement and none are worse than our feeling of commitment that encourages us to hold onto investments longer than we should. The sell decision is based on logic and business prospects in the future. Waiting for an eventual turnaround is useless if a company’s customer base has fundamentally changed, or if its competitive advantages have been eroded by competition. I have scars to show for this misjudgement. Under-selling can be just as detrimental as over-selling.

The evolution of selling

The evolution of any investor understandably begins with focusing on buying, but sophisticated investors that truly understand when and how to sell, transcend into becoming adaptive investors able to compound wealth in any market condition. Adaptive capital is where you ride each wave as it presents itself. To do that, you need to be skillful at braking, not just accelerating.

Happy compounding.

About me

Lawrence Lam is the Managing Director & Founder of Lumenary, a fund that invests in the best founder-led companies in the world. We scour the world looking for unique, overlooked companies in markets and industries on the edge of greatness. We are a different type of global fund - you can visit our website for more articles and information.

Akepanidtaworn, Klakow and Di Mascio, Rick and Imas, Alex and Schmidt, Lawrence, Selling Fast and Buying Slow: Heuristics and Trading Performance of Institutional Investors (September 2019). Available at SSRN: (VIEW LINK) or (VIEW LINK)

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