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Thursday 30 January 2014

You'll Never Grow Rich Taking A Profit

“I made up my mind to be wise and play carefully, conservatively. Everybody knew that the way to do that was to take profits and buy back your stocks on reactions. And that is precisely what I did, or rather what I tried to do.....They say you never grow broke taking profits. No, you don't. But neither do you grow rich taking a four point profit in a bull market.”
Orgasmic Trades

We hate taking a loss, so taking a profit is always good, we usually think.  After all, we’ve locked in our profits, so we can never take a loss on them.  Which is all well and good, if you have a continuous stream of brilliant investing ideas, such that you can replace the stock you’ve sold with one that’s better.

This is worse than loose thinking, it’s not thinking at all.  It’s not the profit we’ve made we should worry about, but the profit we’ve foregone.  It’s the opportunity cost of selling a profitable stock we should be concerned over, not the transient orgasm that comes with the brief thrill of a quick gain. 

Satanic Aphorisms

“You never go broke taking a profit” is a horrible, thoughtless, dumb investing aphorism that deserves to be consigned to the Satanic fires along with tipsheets and day trading.  It’s true, of course, but it justifies a whole raft of otherwise indefensible, idiotic and perverse trading behavior.  Worse still, it panders to one of our most fundamental behavioral weaknesses, loss aversion.  We just hate selling at a loss, so we will grimly hang on to loss making stocks. 

The disposition effect, which is an outcome of loss aversion, adds to this the nasty twist that we tend to sell our winning stocks too soon – which means we no longer run the risk of a loss on that stock (see Brains, Bulls and Lucky Tossers).  Of course, the problem is that we only track the stocks we hold.  So here’s a tip: keep tracking the stocks you've sold and see what the results are.  I can tell you one result – you’ll suffer from an alternative behavioral bias, regret. 

Utility Burned

The general idea about these biases is that they cause us actual pain.  So selling at a loss hurts, and we can avoid the hurt by refusing to sell.  And tracking the stocks we've sold and seeing them soar also hurts – and we avoid that particular experience by simply ignoring the stocks and hoping they'll go away.  Although if we do track them we still won’t repurchase them if they go higher, as Michal Strahilevitz, Terrance Odean and Brad Barber showed in Once Burned, Twice Shy.

That we engage in this peculiar behavior isn't really in question, but why we do it is another matter.  Economists would traditionally argue that we should operate in a way that ensures we gain the maximum utility from our trading behavior – which in that instance roughly equates to maximizing our capital.  But, as you might observe, even allowing for an element of hindsight and the limitations of our brains’ information processing abilities, it would appear that we fall some way short of perfect performance.

Realization Utility

One alternative possibility is that we actually gain utility not from the overall success or failure of our investing actions but from the act of realizing gains – or losses.  This was the idea behind a paper, Realization Utility, by Nicolas Barberis and Wei Xiong, who suspect that we’re more interested in how we evaluate our trades than in the total amount of money we make or lose.  They propose that we use a simple heuristic to guide us:
“Selling a stock at a gain relative to purchase price is a good thing – it is what successful investors do”
They also suggest that another cognitive process is at work – the idea of Event Segmentation, which originated with Jeffrey Zacks and Khena Swallow.  The proposal is that we “segment ongoing activity into meaningful events”:  this affects what we remember and is, largely, an automatic process.  Perhaps the easiest analogy is to think of our brains splitting up our continuous stream of experience into a series of discrete events – in effect, we digitize our own analogue lives.

Barberis and Ziong use this idea to hypothesize the idea of “investing episodes” – a continual stream of discrete events characterized by the investment name, its purchase price and its selling price.  And out of all this we gain utility not in terms of overall wealth but in terms of the pleasure (or pain) associated with the sequence of individual experiences of profits and losses from each of our investments. 

Moot Modelling

Whether the model is actually telling us something about our internal and unconscious processing of investments is moot, but it can certainly explain a raft of puzzling behaviors.  It shows why individual investors continually sell stocks which outperform those they buy and it offers an explanation for the disposition effect. It also predicts a range of other odd but demonstrable market anomalies – the facts that highly valued stocks are heavily traded or that stocks making historical highs tend to be sold quite heavily, for instance.

This latter point is particularly interesting, because the model expects that as a stock goes through a historical high we will see an inflection point.  As the stock approaches the high there will be little selling, because those investors who would gain so-called realization utility from selling at these prices will already have done so.  But once a new high is made there will be a wave of selling from investors who have liquidation points above that price.  Which is exactly what seems to happen in the real market.

Parasitic Memes

These psychological biases don’t prove that people tend to sell too soon, but the idea behind the “you can’t go bust taking a profit” meme is nastily parasitic.  A good parasite doesn't kill its host, because that tends to be a one-way ticket to oblivion.  What it actually does is siphon off enough sustenance to maintain itself and allow its host to continue to forage.  And, of course, this is exactly what the meme ensures – you can’t go bust taking a profit, but you can, and will, continue to provide the securities industry with an annuity income while ensuring that you have no chance whatsoever of growing rich.

The flip side of this, selling stocks that are losing, is equally difficult and equally valid.  But as The Babe Ruth Effect indicates many of the world’s greatest investors actually have more losing trades than winning ones.  But when they win, they win big.  But, of course, if we could all do this we’d all be filthy rich rather than simply not broke.

Psychic Pain

So here’s a challenge.  Don’t just forget about the stocks you’ve sold.  Create a portfolio of sold stocks and track their performance against the ones you’ve bought or continue to hold.  You will likely be surprised at the results.  You may also be consumed with regret and afflicted by waves of psychic pain.   This will cause you negative utility, I shouldn’t wonder.

Still, it’s all in a good cause.  No one said getting rich was going to be easy, did they?  Oh yeah, they did ...  

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  1. What a lot of nonsense. I write the Capital Preservation Real Estate Report and have been following markets for more than 30 years.

    Has the author totally forgotten the disaster of 2008-2009. Investors who held on throughout the entire collapse took an incredible beating. Many have not yet recovered to where their portfolio was in 2007.

    I gave a major presentation in NYC two weeks ago and reminded institutional investors of what had happened to their portfolios during the credit crisis. Many are nowhere near the value of their fund at the peak of 2007.

    Admittedly, timing a market top is very difficult. But recognizing when a market has lost touch with fundamentals is much easier.

    Would the author have held his stocks during the 1929-1932 collapse? I certainly hope not.

    The stock market today is frothy beyond belief and is sending up red flags day after day. Ignore them at your risk.

  2. This article is so off-base! A profit gained is better than a profit lost. If you are always trying to gain that extra dollar you will eventually lose.

    You can get sound advice at my blog

  3. accurate article on trading and psychology. The author talks about the benefit of selling at a small loss rather than holding and hoping It is clear from the article that the author would not have held his stocks through the '29 crash. Its just a good article that defines human behaviour in financial markets which we all as traders can relate to

  4. Amen to what the guy above me said. No one is saying you hopelessly hang on, but rather that you look to maximize your winning trades to the best of your ability, and never simply sell for the sole reason of "taking a profit". It would seem that this concept could be more applicable to traders than perhaps investors.

    I think some really missed the point here...

    Thanks for the good read.

  5. Keith dont be ignorant. No where in this article did it say buy and hold for a year or 2! Its simply saying to examine from past trades how much money is being left on the table..

  6. Very good piece: I feel some of the comments in reply completely miss the point, it is not just about holding a stock (or any trading/investment risk position be it long or short), it is also about having a relationship between the size of gains relative losses. I.e. If you have an equal number of profits to losses then holding winning trades twice as long as losing trades should lead to out-performance. Equally on a 30/70 win to loss ratio ( which us more realistic), holding winning trades twice as long as losers would see capital eroded, in the same parasitic way the article alludes to. However running wins on avg 3 times as long as losers would see this reversed. Too any traders I work with I am a performance coach) make this error, the right advice should be 'you never go broke taking a loss'.

    There is one exception to this rule is that of the market-maker Think the house in a casino), they are on the other side of the trade and wants to be accumulating many small profits which they hope will cover the occasional bigger losses, they are quite happy for investors to believe e 'you never go broke taking a profit'.

  7. Good article. Our emotions are our own worst enemies when it comes to investing. I am guilty of pretty much all the behaviours described - but I am aware of that and have built up some investing rules to help me deal with this. The most important is the 'sell' rule, which is to only sell when I have made a capital gain equivalent 5 years worth of income (I am a high-yield income investor). It's not perfect, but it helped me keep invested during the 2007/08 collapse and recovery.

  8. Okay, but when should you take a profit then? Is it about setting targets based on charts, fundamentals or what?