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Secret #8: Remove the weeds and water the flowers — not the other way around

For many it is worse than having a tooth pulled to sell a stock for a price lower than what they paid for it. If you buy a stock for Rs.20 and it drops to Rs.10, so long as you don’t sell, then it can be referred to as an unrealized loss. In this case you can say to your spouse, “Don’t worry, dear. It’s going to come back.”

Similarly, many can’t wait to sell as soon as they can see daylight between the purchase price and the current price. If the price has gone up be a few dollars, they want to sell and “lock in the profit”.

Peter Lynch and later Warren Buffett referred to this as watering the weeds and pulling up the flowers. They are examples of what I call investor diseases. The disease of holding on to your losers I call get-evenitis. The disease of selling winners I call consolidatus profitus. Just how wide-spread these diseases are follows from a large-scale study carried out by Terrance Odean of the University of California in Davis. His study also showed just how expensive they are, being paid for in investors’ profits.

Reporting in the Journal of Finance, 1998, he found that people tended to trade out of winners into stocks that performed less well. In the opposite direction, the study showed that the losers in their portfolio tended to continue to underperform. It was really the case that once a loser, always a loser.

Overall he found that people would have been better to sell their losers and keep their winners. Instead, they did the opposite, namely keep their losers and sell their winners. Suppose two simple changes were made: the investors sold their losers and held on to their winners. On average, the study showed that their average annual performance would have gone up by almost five percent per year.

The difference between the two strategies is even more marked when taxes are taken into account. When you claim a loss you are getting a tax rebate and so you want this as early as possible. In contrast, with a profit you are paying tax so you want to delay this as long as possible. But, as we just learned, the average
investor tends to take profits early and losses late ending up on the wrong side of the taxman.

This gives us confirmation of secret number eight: Remove the weeds and water the flowers — not the other way around Of course, this is an oversimplification. There are times when it is better to keep a stock when the price has gone down. In fact, it may well make sense to buy more. At other times, it is better to sell a stock after it has gone up. Each case has to be treated on its own merits.

This leads to the question. Just when should you sell? A large survey carried out by the Australian Stock Exchange showed that investors found it much harder to know when to sell than when to buy. Similar results were found in a survey of nearly 300 investors that I carried out. Almost 50 percent said that they either regularly worry or constantly worry about when to sell their stocks.

The general rule which is full of common sense is: Sell only when you can be very confident that you can do significantly better with your money in another stock. The problem is to be able to determine when this is the case.

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