Time to Sell?

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The market's been going up pretty steadily and it's been going up fastest in the segment of the market that retail investors have been most attracted to. And so it's very easy to think that you have figured stuff out and you'll be entitled to that opinion when you've also figured out when to sell and which parts to sell. And then you've done that 10 10 times. And if you think you've figured it out right now, think again.

Welcome to the Barron Streetwise Podcast. I'm Jack Howe. The voice you just heard is Richard Thaler. He's a Nobel economist and co-founder of Fuller Thaler, an asset manager. Professor Thaler studies behavioral economics, or how psychology affects Financial decision-making. We'll hear more from him in a moment about investor overconfidence and why figuring out when to sell is so hard. We'll also talk with Michael Hartnett, Chief Investment Strategist at BofA Research, about why the stock market outlook for 2021 isn't all sunshine and rainbow-sprinkled cupcakes. More like rain. And low-carb muffins. Bran, not chocolate chip. Listening in is our audio producer Meta.

Hi, Meta. Hey, Jack.

I understand we have a listener question about selling. We do. Let's hear it.

Hi, Jack and Meta. My name is Roshan, and I'm calling from London in the United Kingdom. Big fan of your show, and I always look forward to some of Meta's sound effects in the background.

Well, thank you, Roshan. You know, it's not easy finding audio elements that properly capture the complexity and gravitas of financial markets, right, Meta? Roshan, you were saying?

My question is on when to sell a stock. Should my strategy be to hold on to the stock forever, like what Warren Buffett says, or should I be looking to lock in some gains and then reinvest those gains during dips in the market? Thanks a lot. Please keep up the good work.

It's a great question, Roshan. There are many different approaches to selling. Some investors use rules like selling stocks after an earnings disappointment or two. Growth investors sometimes sell when they see signs that their thesis on a company is no longer playing out— a big deceleration in revenue gains, for example. And value investors often sell when shares no longer look cheap. In an earlier episode of this podcast, we talked about valuation using predictions of future cash flows to calculate how much to pay for stocks today. That process can work for figuring out when to sell too, but of course it's filled with uncertainty. We won't go back into valuation here, and selling is too big of a subject to cover in full, but maybe we can find some useful tips. One thing I can tell you from the start is that although Warren Buffett says his favorite holding period is forever, he does plenty of selling. Last quarter, his investment conglomerate Berkshire Hathaway reported 11 stock sales, including big reductions in banks and a gold miner, and a trim of its biggest holding, Apple. Another thing I can tell you is that I try to do as little selling as possible because I'm pretty sure I stink at it, and I don't think I'm alone. A recent study looked at the buying and selling decisions of institutional money managers in charge of hundreds of millions of dollars. Here's a quote from that paper: A striking finding emerges. While there is clear evidence of skill in buying, selling decisions underperformed substantially, even relative to random selling strategies. What does that mean? Well, let me put it this way. There's a bar I've written about in Austin, Texas called the Little Longhorn Saloon. It bills itself as the honkiest, tonkiest beer joint in town. There's another way it bills itself. Meta, keep your finger on the bleep button for this one. I I have to use some salty language. The original home of chicken shit bingo for more than 15 years. Now, if you've never seen this particular game of chance played, it works like regular bingo except instead of drawing numbers, there's a chicken that walks around on a number-covered board until inevitably nature calls. The location of the droppings determine which numbers are called. Okay, so imagine those boards were filled not with numbers but with ticker symbols from a stock portfolio. The research suggests that a typical institutional money manager, someone who charges for this, would be better off letting the chicken make the selling decisions. Why are people so bad at selling? Let's come back to that question and the study in a moment. By the way, the Little Longhorn Saloon has been shut down by the pandemic, and its owner Terry has been doing what she can to get by and keep the spirit of the saloon alive, including online events and some off-site services. We wish her luck, and if you're in the Austin area and you're looking for a traveling chicken shit bingo operation, you might want to make Terry an offer. She has 3 hens to choose among: Loretta Lynn, Dolly Parton, and Patsy Cline. Now then, the fact that money managers appear to be better at buying than selling suggests the problem isn't a lack of analytical skill. Maybe the problem is rooted in behavioral quirks. I had a chance recently to speak with a leading authority on investor behavior, Professor Richard Thaler.

Hi, it's Jack Howe. Hey, Jack. This isn't video, right?

No, no. Although you look great.

Oh, thank you very much.

And the books behind you are very scholarly, too. Professor Thaler was awarded the Nobel Prize in Economics in 2017 for his work in what's now called behavioral economics. It's the study of how things like emotions can cause people to make financial decisions that seem strange on paper. And it has plenty of practical implications. If you've started a new job in recent years with a 401(k) plan, and if instead of waiting for you to enroll, the plan enrolled you automatically unless you opted out, that behavioral nudge was based in part on Professor Thaler's research. It has increased plan enrollment and savings. Professor Thaler wrote a 2008 book about nudges with a lawyer named Cass Sunstein.. It's called nudge. Professor Thaler is also co-founder of a money management firm, Fuller Thaler, that looks for opportunities where it believes investors have under- or overreacted to company developments. I asked Professor Thaler how he got involved in behavioral economics. He says it goes back to when he was a graduate student.

So it's an overnight sensation that took decades. I was being taught standard economic models that assumed that everybody's really smart and unemotional and has no self-control problems and never has hangovers, saves perfectly for retirement. And, you know, if I would look around, that's not what I saw in the world. And slowly I started trying to think about how you could create a different kind of economics that would include real people.

I asked Professor Thaler which tendencies from behavioral economics are relevant today.

He says they all are. It's not that people have gotten any smarter in 40 years, so I don't think there's any problem that we were studying early on that is no longer relevant because people have figured out how to stop making that mistake. Where we've had success is in creating institutions that make it easier for them to avoid those mistakes.

One of the biggest mistakes investors make is overconfidence. People think they're better than average at almost everything, Professor Thaler says. If you ask them where they rate themselves on, say, sense of humor, they'll all say near the top. But of course, not everyone can be better than average. That's particularly relevant now because we've seen a big increase in retail investors buying individual stocks, and the world seems to be conspiring to make them believe they're good at it.

Here's Professor Thaler. The market's been going up pretty steadily, and it's been going up fastest in the segment of the market that retail investors have been most attracted to. And so it's very easy to think that you have figured stuff out and you'll be entitled to that opinion when you've also figured out when to sell and which parts to sell. And then you've done that 10 times. And if you think you've figured it out right now, think again.

I'm pretty sure when it comes to avoiding overconfidence, I'm a 10 out of 10, right, Meta?

I think I'd place you at a solid 6 out of 10.

Hmm.

What about sense of humor?

That'll be a 5.5.

Sounds above average to me.

It is. And that brings us to another phenomenon from behavioral economics called loss aversion. We touched on this during a recent episode of this podcast on art. People tend to feel the pain of losing money much more acutely than they do the joy of winning money.. And that can lead them to some odd behavior when it comes to selling.

Here's Professor Thaler. If you have a winner and a loser and you have to sell something, the smart thing is to sell the loser because the government will share your gains or losses, and you might as well share your losses with the government rather than the gains. But selling a loser means admitting to yourself that you made a mistake. And so what we observe is that people hold on to their losers longer than their winners.

That's not to say that investors should sell all stocks that go down, of course, but they should be aware of the tendency to put off selling for too long. As Professor Thaler puts it, the challenge is not just to declare a loss on an accounting basis, but to declare it to yourself. The flip side of loss aversion is that investors are sometimes too quick to sell winners to lock in gains before things go bad. So even if your holding period isn't forever, be aware of that tendency too. Consider carefully before letting go of winners. Those are pretty broad suggestions, I realize. Let's go back to that study I mentioned, the one that shows that "Big Money Managers Tend to Be Pretty Good at Buying but Terrible at Selling." It's by a colleague of Professor Thaler's at the University of Chicago named Alex Imus and some partners of his. The paper theorizes that the difference between buying and selling performance is owed to, quote, "an asymmetric allocation of cognitive resources such as attention." In other words, money managers might simply not pay careful enough attention to their selling decisions. I know that sounds weird, but consider the evidence. The researchers found that returns were much better in cases where stocks were sold around the release of company earnings reports than in cases where they were sold between earnings reports. One thing we know about earnings reports is that big shareholders tend to pay careful attention to them. In other words, the more attention portfolio managers were paying the better they seem to do. Earlier research has suggested that investors tend to be more forward-looking and belief-driven in their buys than in their sales. In this study, the researchers say anecdotally that in interviews with their portfolio managers, many suggested they spend most of their time looking for their next great stocks and view selling mainly as something to do to raise money for new purchases. I realize there are more questions here than answers about selling, Roshan, but the study results at least suggest that you should put as much analysis into selling as you do into buying. If these portfolio managers had done merely as well in selling as a random decision-making process, like say letting Loretta Lynn or Dolly Parton or Patsy Cline choose on a bingo board, they would have added nearly 2 percentage points a year to their average returns. In money management, that's a return difference that can make or break a career. Let me return to Professor Thaler, and after, maybe we'll have one or two more things to say about selling. I asked, what kind of investment opportunity should investors be looking for after the pandemic? Professor Thaler says he's not a big fan of trying to predict the future.

I think individual investors, the best long-term strategy is benign neglect.

Create a sensible long-term portfolio and then ignore it. Professor Thaler and his Nudge co-author are working on an update to the book. He says they'll call it the final edition so they're not tempted to update it again. He says this version introduces the term sludge to mean process and paperwork type things that stand in the way of stuff getting done. I guess you need a nudge to get past the sludge, something like that 401(k) enrollment that gets people past putting off enrolling.

I asked for another nudge. Here's an idea that it's just criminal that we haven't done, which is why aren't we sending everyone that takes the standard deduction a pre-filled tax return? Now, you know, after the most recent tax reform, almost 90% of American taxpayers take the standard deduction. And for virtually all of those, the IRS already has all the information necessary to do their taxes.

Professor Thaler says the tax return industry has worked to block prefilled returns and that the IRS is prohibited from sending them. But that if he ruled the world, he'd change that. One consequence would be that poor people who earn income would all receive a payment they qualify for called the Earned Income Tax Credit without a lot of fees and paperwork. Here's another of Professor Thaler's ideas to provide more opportunity to the poor. Colleges, he says, should reach out to low-income, high-achieving high school students who could qualify for scholarships rather than waiting for them to apply.

There are tens of thousands of parents out there helping their kids write essays. And again, if I ran the world, I'd get rid of all those stupid essays which predict virtually nothing except which parents are willing to help their kids or pay somebody to help their kids, and instead just make it easier for kids to apply. And the really sad thing is the top schools like the University of Chicago, it's essentially free for any kid from a low-income family to come in, but we can't get enough to apply.

Roshan, let's come back to selling. Maybe one reason you're asking about selling now is that With the stock market doing so well, you're wondering whether to take profits in general. At this time of year, a lot of investment banks publish reports with predictions for the coming year. Many have been bullish, with vaccines and a reopened economy right around the corner. But BofA Global Research, part of Bank of America, put out a report with a piece of advice that caught my attention: sell the vaccine. In other words, sell stocks into the strength that vaccines will provide in coming months. To learn more, I reached out to Michael Hartnett. He's the Chief Investment Strategist for BofA Global Research. Hi, it's Jack Howe from Barron's. How are you? Good, yourself? Doing well, thanks. Michael says March of this year brought extreme fear from the pandemic and economic shutdown, and a stock crash combined with a powerful policy response in the form of interest rate cuts and stimulus spending. And that 2021 could bring the mirror image of that.

What the vaccine will do will sort of generate the mirror image, you know, in terms of circumstances in that you'll have peak positioning because the vaccine will cause a moment, if you like, of maximum optimism. And you'll have a moment of peak policy stimulus, because if we're taking a vaccine and emerging from our caves and traveling and going back to offices, there will not be the need for monetary and fiscal stimulus. And let's face it, I mean, the reason the markets are where they are is because you've seen $20 trillion of monetary and fiscal stimulus in the past 8 months.

So peak positioning and peak policy. And Michael sees a third peak.

Profits, or at least expected profits. The market has its maximum expectation, if you like, of economic growth and corporate earnings on the back of a vaccine. So the vaccine, as it should— and it's great that it happens and it's great that it works— but what it is likely to do, you know, in this bizarre place called Wall Street, it's likely to create a moment of peak positioning. Peak policy, peak profits, and inevitably that causes peak prices. And I think that's gonna be an early year theme for 2021.

Now this advice is for tactical investors, not those who simply buy and hold like I try to do. Michael says it's not time to get defensive yet. In other words, to shift to safer investments. He's waiting for, as he puts it, another 6 to 8 weeks or 6% to 8% gain. Then he thinks it could be time to shift some money to cash, treasuries, and defensive stocks with good dividends like utilities, consumer staples, and certain real estate investment trusts. He also says inflation could pick up, so if you buy treasuries, you might want to make them the inflation-protected variety. Those are called TIPS. Michael likes gold too, although he says It's run up lately, so you might want to wait for, as he puts it, a digestion period. If you do shift some money into safe havens, you might not want to leave it parked there forever.

Here's Michael. Those would be naturally areas that would protect you, but, you know, they obviously work much better if there is, you know, sustained downside. And I think more likely what you're moving into is just a very volatile, fat trading range. So far as the market is concerned. So you're going to have to be quite nimble, you know, with those assets, I think.

Thank you for listening. Metalootsoft is our producer and audio Jedi. Thank you, Roshan, for sending in your question. And everyone, please keep the questions coming. Just tape on your phone and send an email to jack.how@metalootsoft.com. That's H-O-U-G-H, at barons.com. Subscribe to the podcast on Apple Podcasts, Spotify, or wherever you listen to podcasts. And if you listen on Apple, please write us a review. If you want to find out about new stories and new podcast episodes, you can follow me on Twitter. That's @jackhowe, H-O-U-G-H.

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