This Is Why You Don't Sell Your Winners

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When it comes to investing, there's no shortage of bad advice floating around out there. Among the worst, though, is the old saw, "You can't go broke by taking a profit."

The saying refers to the belief that if you have a stock that's gone up in value, it's hard to go wrong selling that stock and "locking in" the gains. But while the saying is technically true -- it's hard to picture a scenario where an investor is suddenly bankrupt after selling a stock at a profit -- it's a dangerous platitude for investors to follow.

There's a name for that
The practice of selling winning stocks and hanging on to losing ones is a practice that's familiar to behavioral-finance experts. It's a behavioral bias known as the disposition effect and has been revealed to be quite harmful for investors. A number of academic papers have shed light on the subject, including Berkeley professor Terrance Odean's 1998 study that concluded that individual investors' "preference for selling winners and holding losers ... leads, in fact, to lower returns."

A possible explanation
If the long-term returns from stocks were distributed normally -- that is, they formed the familiar bell-shaped curve and most stocks' returns clustered around the average -- selling winners and holding losers might actually work. If the returns from most individual stocks were likely to be right around the average for all stocks, then a big winner would be more likely to stall out after its winning streak than continue climbing. At the other end, it wouldn't be unreasonable to expect a stock that's been a big loser to climb back closer to the average.

But that's not how it works.

I was reminded of this by a recent report by Shankar Vedantam for NPR, called "Put Away the Bell Curve: Most of Us Aren't 'Average.'" Vedantam reviewed the research and work of Ernest O'Boyle Jr. and Herman Aguinis, who studied the performance of 633,263 people involved in academia, sports, politics, and entertainment.

In short, the pair's finding was that the performance distribution in these groups wasn't bell-shaped. Instead, many participants clustered below the mathematical average, while a group of superstars produced results far above the average and pulled the overall average up.

Stock returns have a similar distaste for fitting to a bell curve. Over the past 10 years, 63% of the S&P 500 companies underperformed the average. Meanwhile, a large group of significant outperformers delivered returns that were well above the average.

Source: S&P Capital IQ.

As compared with the bell curve in the background, the data plotted here is a mess. And it should be. Stock returns are not normally distributed -- which is what produces that nice bell-shaped curve. And though stats-stars who are much smarter than me often try to describe stock returns as "lognormal" -- a mathematical transformation of the returns that gets them to more closely fit a bell curve -- they're not that, either. Stocks are typified by "fat tails" on either end -- that is, more seriously outperforming and underperforming stocks than is easily captured by streamlined mathematical models.

So no matter how you look at stock returns, a surprising number of stocks end up returning far more and far less than the average. Practically, this means that the practice of "locking in gains" and hanging on to losers is a good way to miss out on the market's huge outperformers, stay stuck with poor performers, and earn lackluster overall returns.

Three lessons
The next question for many stock-pickers is this: How do I know which winners to hold on to? If there was an easy answer, then we'd all be Warren Buffett. But here are three important points that are underscored by the returns from the S&P stocks over the past decade.

  1. Don't buy or sell on price alone. The price of a stock and how much it's gone up or down is just not meaningful on its own. For years, many investors looked at Apple's (Nasdaq: AAPL  ) stock and avoided it because the stock had gone up so much. The company kept right on growing, though, and that growth backed up the stock's tear. As of today, it's the S&P's top performer over the past decade. But that huge gain means little when considering whether Apple's stock will go up or down from here -- it matters far more what the business does in the future.
  2. No need to swing for the fences. If you want to capture the huge gains on the left end of that chart, you don't necessarily need to chase small up-and-comers that are pioneering new technologies. Among the S&P's very best performers over the past decade are Caterpillar (NYSE: CAT  ) and Nike (NYSE: NKE  ) -- both older companies in traditional businesses that simply do what they do better than their competitors. And the fact that both companies continue to perform well suggests that there's still no reason to abandon solid businesses like these today.
  3. No silver bullet. Good luck trying to use any one thing as an answer to finding the best-performing stocks. As much as I love dividends, that metric alone may have hurt more than it helped over the past decade. At the outset of the 10-year period (2002), five of the top 10 performing S&P stocks paid a dividend. Meanwhile, nine of the 10 worst-performing stocks paid a dividend. Focusing on one industry wouldn't have been much better, since basically all of the major industries were represented among the top and bottom performers.

While it may seem that equity investing lacks easy answers, there actually are two. One is to not bother trying to find the market's super stocks at all and instead just capturing the market's performance as a whole by buying a low-cost index. The other is to quit relying on simplistic stock market sayings and rules of thumb and instead get your hands dirty researching and learning about the companies you're investing in.

If you're brave and diligent enough for the latter, a good place to start is with The Motley Fool's new special report, "3 American Companies Set to Dominate the World," which details three S&P 500 companies that may be big winners in the coming years thanks to their strong global footprints. You can get a free copy of that report.

The Fool owns shares of Apple. Motley Fool newsletter services have recommended buying shares of Apple and Nike, creating a bull call spread position in Apple, and creating a diagonal call position in Nike. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.

Fool contributor Matt Koppenheffer has no financial interest in any of the companies mentioned. You can check out what Matt is keeping an eye on by visiting his CAPS portfolio, or you can follow Matt on Twitter, @KoppTheFool, or on Facebook. The Fool's disclosure policy prefers dividends over a sharp stick in the eye.

Read/Post Comments (7) | Recommend This Article (42)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On May 10, 2012, at 7:37 PM, midnightmoney wrote:

    A very well-written and well-reasoned article that draws nicely on statistics and makes them palatable, even intriguing. I Would love to see more of this kind of writing.

  • Report this Comment On May 11, 2012, at 11:02 AM, StopPrintinMoney wrote:

    Nicely written, but I prefer "take the profits and cut the loses"

  • Report this Comment On May 11, 2012, at 11:32 AM, Intiinvestor wrote:

    Good article..Thanks Fool...

  • Report this Comment On May 11, 2012, at 11:57 AM, Bonsaiscrooge wrote:

    One reason why investors prefer cashing in the profits over the losses might be to avoid the pain of realizing the loss. Yet, even a realized profit is only truly "realized" if it is finally consumed and not waiting to be re-invested.

    In order to minimize the pain of cutting a loss, I usually realize it together with a profit if I have to sell a winner because of the latter stock going private or being taken over or other reasons forcing me to sell.

    As a longterm investor with a large number of stocks in a highly diversified portfolio I experienced in the last 40 years that the winners nearly always outnumbered the losers, hence, there was always an opportunity for "painlessly" cutting losses.

  • Report this Comment On May 11, 2012, at 12:38 PM, daillengineer wrote:

    could always buy puts when you're afraid you might lose a winner in the short term. this will give you peace. or you could also sell covered calls and increase your returns when you think it'll trade sideways.

  • Report this Comment On May 11, 2012, at 1:23 PM, rossirina wrote:

    My approach is to keep a long term perspective and avoid trying to time the market. Based on a plan I got from and on all the interesting staff they write I am mainly into ETFs. Look at the chart and see once more that we always compare results to the average and we have more losers than winner. Here again ensuring the average with minimal management fees is a safer way to build wealth over time, especially that I can't afford to build a diversified enough portfolio.

  • Report this Comment On May 11, 2012, at 2:15 PM, TrojanFan wrote:

    This is a great article and it answers a question I have long wondered about regarding the distribution of returns in the major averages. While I didn't know the answer, just from anecdotal investing experience I had an intuitive sense that the distribution probably looked something like this.

    So here are a couple of obvious follow up questions from my perspective.

    1) If 63% of the sample set (nearly 2/3rds of the group) underperformed the average over a 10 year period (a long enough time span to wash away the effects of sentiment and bad luck and be considered statistically significant) and the object of direct active investing as opposed to index investing is to do better then the market average, doesn't it logically follow that far more investor should be spending far more capital and energy shorting the market then what is currently done or encouraged by the financial planning community? Wouldn't it be fair to say that on could expect better results if they did that given the market's overwhelming propensity to excessive optimism and bullish biases?

    2) Doesn't this really argue against the merits of passive investment strategies (mutual funds, annuities, ETFs, etc.) where the investor delegates away the stock selection and portfolio management responsibilities along with their hard earned savings dollars to a manager in exchange for an annual fee charged on assets every year whether the manager beat the average or not? This question is predicated on the assumption that these large asset pools basically buy the basket and make minor tweaks to overweight or underweight specific industries or sectors which is in fact what most of them do. Wouldn't most of us be better off if we fired are managers and took charge of our own investments even if it is somewhat time consuming to do given that 2/3rds of the active managers picks are likely to be below average and they are going to be compensated the same fee regardless of whether their performance is above or below average? Sure, a whole lot of investment management professionals would be out of a job, but I'm okay with that because they're really smart and well educated by and large and should easily find some other productive endeavor to channel their considerable intellectual and creative energies into with little difficulty.

    3) Isn't one of the whole points of investing and the invisible hand theory of capitalism to guide people and resources out of overcrowded areas and into areas with less competition? I would be very interested to see a research piece on the relative distribution of bulls and bears (long capital vs short capital) in the market at any given time. Or how many firms and professionals are on each side of the trade. We spend so much time being bullish and trying to pick winners, but look how crowded that side of the trade is. My intuitive sense is that the other side of the trade is far less crowded and suffers less from the intense competition that plagues the long side of the market. This isn't just a philosophical musing either. It is my strong suspicion that this misallocation of intellectual energy and effort to the side of blind optimism (the bullish side of the market) as opposed to the side of healthy skepticism and even just a slight touch of jaded cynicism (the bearish end of the market) is one of the reasons we keep seeing these asset bubbles of considerable magnitude getting inflated and popped with increasing frequency and intensity to the considerable detriment of the economy at large. If there was more of a buttressing force leaning against this irrational exuberance wouldn't that tend to moderate these ill effects to a greater degree and keep our economy in a better state of balance? Shouldn't we be encouraging more investors to short more stocks to a greater degree? Isn't depriving firms of capital that don't deserve it just as important as promoting capital formation among the firms that do?

    I would like to see an article that delves into this considerable imbalance among the participants that populate the market and the ill effects that such an imbalance promotes. I think the 2/3rds of below average performers is signalling that we need more shorts in the market, or at least that we needed them 10 years ago. I really don't think the circumstances surrounding this imbalance have changed very much in the last 10 years, though.

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