Hacksaw backscratch

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  By Guest Blogger Doug Rowat

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Can you take my portfolio to cash?

Naturally, we get this request from clients during bear markets. It’s a terrible idea for countless reasons, reasons that I’ve, to paraphrase legendary Pittsburgh Penguins broadcaster Mike Lange, beaten like a rented mule here many times. So I’ll spare you from doing it again.

However, what about the question that typically comes next: Can’t we just raise SOME cash by selling the stuff that’s gone up?

Ah yes, the disposition effect. The tendency of investors to sell assets that have gone up in value while keeping the assets that have declined in value.

The disposition effect can be demonstrated through a simple exercise. Suppose you buy two securities, one at $25 and one at $100. Overnight the $25 security doubles and the $100 security drops 50%. Assuming that you must sell one of the two, which security do you sell? The temptation for most investors is to sell the security that’s doubled, but this decision is arbitrary as the actual economic impact on the portfolio is identical. A more logical approach would be to simply flip a coin, but in practice, as the research of Professor Terrance Odean at the University of California Berkeley has shown, individual investors are almost 4x more likely to choose the ‘take profits’ option.

Individual investors have a built-in impulse to sell winners. Simply put, it ‘feels better’ to take a profit. This is why, regardless of market conditions, if clients need to raise cash, say to purchase a used car, they usually request that we sell holdings that “have gains”. But such requests aren’t rational, they’re emotional.

To make matters worse, the urge to sell winners actually increases when markets are in a downturn. Author and investor Scott Nations notes the following in his new book The Anxious Investor:

Another reason we can debunk the idea that investors are being their best selves when they’re selling winners is because the tendency increases when prices are falling, as demonstrated in a 2021 study of nearly a hundred thousand German individual investors from 2001 to 2015. Researchers found that these investors were “25 percent more likely to realize gains in bust than in boom periods.” [The disposition effect] increases as prices fall because investors who are watching the value of their portfolio dwindle are looking for a little good news and the only way to achieve that is to sell winners just when they become more important to the overall health of a portfolio.

It’s a cognitive fallacy, of course, to assume that winning positions will underperform in the future and losing positions will outperform. If one assumes an equal probability of a winning position either outperforming or underperforming down the road, there can be no justification for selling winning positions 4x more often than losing positions.

Another consideration is that the powerful effect of positive market-momentum, combined with the terrible security selection of individual investors, actually indicates that the selling of winning positions is a bad idea EVEN if it’s done in equal proportion to the selling of losing positions. Scott Nations further notes:

One study of ten thousand brokerage accounts from 1987 through 1993 found that these investors were more likely to sell winners than losers and that the winners they sold outperformed the losers they kept over the following year by 3.4 percentage points. Another study of Japanese individual investors during that country’s bull market from 1984 to 1989 was even starker; the stocks these investors sold outperformed the stocks they purchased by a total of 38.2 percentage points.

One more reason to let your winners ride. But regardless, it’s still the disproportionate frequency with which individual investors sell their winners that isn’t logical. It’s a decision driven only by our need to record successes at the expense of carefully considered forecasting.

But to become a truly successful investor means giving yourself constant wake-up calls. It means forcing awareness of your behavioural biases. To again paraphrase Mike Lange, it means scratching your back with a hacksaw.

So stop selling your winners just because it feels better to do so.

You’re welcome. I’ll lay down my hacksaw.

Doug Rowat, FCSI® is Portfolio Manager with Turner Investments and Senior Investment Advisor, Private Client Group, Raymond James Ltd.