Howard Marks is a well-known American investor and writer who writes insightful memos to the clients of his investment firm, Oaktree Capital Management.
On Friday (14 January), Marks released his latest memo entitled “Selling Out”.
The memo explores one of investing’s most fundamental questions of when we should sell our investments.
Marks’ latest memo resonated with me so much that I thought I should spend some time reflecting on it.
Here are some of my favourite parts from the memo, together with my own commentary.
Too Much Activity ≠ Outperformance
One of the biggest myths in the stock market is that you have to actively buy and sell to do well in the stock market.
In his memo, Marks says that when we find an investment with the potential to compound over a long time frame, one of the hardest things is to be patient and maintain your position for as long as necessary.
Investors can easily be distracted to sell due to news and emotions such as fear and greed.
This reminds me of a research paper that was published in 2005 titled “Action bias among elite soccer goalkeepers: The case of penalty kicks”.
In the study, researchers performed an analysis of 286 penalty kicks in top leagues and championships worldwide.
They found out that penalty takers shoot the ball to the right of the goal 1/3 of the time, to the left 1/3 of the time, and to the centre 1/3 of the time.
The paper also revealed that a goalkeeper picks a side and dives 93.7% of the time and stands in the middle merely 6.3% of the time.
There was a clear bias towards action.
With 30% of the kicks right down the middle, the optimal strategy is to obviously stay in the middle.
However, by staying rooted without doing anything, the goalkeeper might feel he is portrayed as being incompetent, thus the need to dive.
The propensity to act even though the action may result in something less desired is termed “action bias”.
Similarly, the higher the activity in an investment portfolio, the higher the chance for our investments to do poorly.
So, the next best course of action (or inaction, in this case) is to just “sit on your ass”, in Charlie Munger’s words.
In his book, “Poor Charlie’s Almanack”, Warren Buffett’s partner Charlie Munger said (emphasis is mine):
“If you buy a business just because it’s undervalued, then you have to worry about selling it when it reaches its intrinsic value. That’s hard. But if you can buy a few great companies, then you can sit on your ass. That’s a good thing.”
Like the goalkeepers, you don’t need to “dive” just for the sake of diving. Sometimes, not doing anything is “doing something”.
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Selling Because Price is Up (or Down)
Most investors sell after a company’s share price runs up as they are afraid that the profits will vanish.
However, there comes a reinvestment risk when the released capital has to be deployed into another company (not considering the time taken to research into a new company again).
What if, decades later, the company that you sold would go on to produce a better return than the new one that you decided to recycle capital into?
So the best course of action would be to just hold on to the winners. You should never interrupt the power of compounding without any concrete reasons (more on that later).
In a podcast at the end of 2018, David Gardner, one of the co-founders of The Motley Fool, shared his takeaways from 200 months of stock picking for an investment newsletter service in the US.
One of his learning was you lose far more on a potential winner than you can on a loser. He said in the podcast (emphases are mine):
“But the real biggest loser for you, if you’re an investor and if you’ve been acting over the long term, I bet you realize that it’s not the bad-performing stocks. It’s the megawinners that you sold too early. It’s that you didn’t stick with big winners…
If you ever have had a wonderful winner in your portfolio and you sold it too early, that is by far a more criminal act on your portfolio. You’re doing far more abusive damage to your own financial future than if you pick a really bad stock and watch it lose most of its value.”
On the other hand, you shouldn’t sell stocks just because they have fallen.
Yes, it’s painful to see losses in our portfolio, but that’s just part and parcel of investing.
If the companies you have bought are of high quality in the first place, and there are no fundamental changes to the business, then any fall in the stock price provides an opportunity to own more of the company at a cheaper price.
Therefore, it’s plain foolish to sell just because prices are up or down. Most of the time, staying invested is ultimately “the most important thing”, in Marks’ words.
So, When Should You Sell?
Selling a stock should never be based on emotions; there must be concrete reasons for selling.
The reasons should be “based on the outlook for the investment – not the psyche of the investor – and they have to be identified through hardheaded financial analysis, rigour and discipline”, says Marks.
In Marks’ view, selling should be done only if:
1. “If your investment thesis seems less valid than it did previously and/or the probability that it will prove accurate has declined, selling some or all of the holding is probably appropriate.”
2. “Likewise, if another investment comes along that appears to have more promise – to offer a superior risk-adjusted prospective return – it’s reasonable to reduce or eliminate existing holdings to make room for it.”
But you shouldn’t look at selling in a vacuum. It should be evaluated in terms of “opportunity cost”.
Some questions to ask would be:
- What will you do with the proceeds? Do you have something in mind that could produce higher returns?
- What will you give up if you continue to hold the stock instead of making the change?
If you are looking to leave your proceeds in cash (not planning to reinvest), a key question to ask would be: Why would holding cash be superior to holding on to the stock that you just sold?
Marks goes on to explore the topic of selling your stock when there’s a temporary share price dip and buying it back later when the price recovers.
He says it’s not generally a good idea to sell for purposes of market timing, which I agree wholeheartedly.
Many studies have also shown that market timing doesn’t work.
For example, a study by Index Fund Advisors showed that for a 20-year period from 1994 to 2013, the S&P 500 index averaged an annual return of 9.2%.
A $10,000 initial investment would give around $58,000 at the end of 2013.
However, if an investor had missed out on just the 10 best days of the 20 years, the average return would have fallen to 5.5%, meaning the final investment amount would only be halved at about $29,000.
The pioneer of index funds, John Bogle, once mentioned:
“Sure, it’d be great to get out of stocks at the high and jump back in at the low… [but] in 55 years in the business, I not only have never met anybody who knew how to do it, I’ve never met anybody who had met anybody who knew how to do it.”
Therefore, it doesn’t pay to time the market; time in the market is more important.
The Cardinal Sin in Investing
Marks ends the memo by commenting:
“Usually, every market high is followed by a higher one and, after all, only the long-term return matters. Reducing market exposure through ill-conceived selling – and thus failing to participate fully in the markets’ positive long-term trend – is a cardinal sin in investing. That’s even more true of selling without reason things that have fallen, turning negative fluctuations into permanent losses and missing out on the miracle of long-term compounding.”
Enough said.
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