FOOL ON THE HILL
To Sell or Not to Sell

Studies show that investors cling to stocks they own that have declined, even when they have lost confidence in them. With so many stocks down this year, it is especially critical now that investors think rationally about whether to buy more, hold, or sell their losing stocks.

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By Whitney Tilson
December 5, 2000

I'm interrupting my series on how to analyze cash flow statements and calculate free cash flow because some of the emails I received after last week's column are troubling me. After reading the first part of my analysis of Lucent's (NYSE: LU) weak cash flows, a number of readers emailed me with comments like these:

"I am with LU to the bitter end."

"I am a recently laid-off former Lucent employee and I thank you for explaining why the stock has 'gone to hell in a handbasket.' However, I wish I would have known before what was left of my 401(k) went out the window. Will I ever get any of it back?"

What troubles me about these emails is that these investors, I fear, are not thinking rationally about their decision to buy more, hold, or sell their Lucent stock. It might well be a good investment at today's prices (I won't be expressing any opinion on this until I finish analyzing Lucent's cash flows in my next two columns) but I think many investors are holding this stock -- and others that have fallen precipitously -- for the wrong reasons.

They're hanging on not because they firmly believe that it is among their very best investment ideas today, but because they are hoping that the stock will rebound to the price at which they bought it so they can sell without incurring a loss. This is among the most common -- and costly -- mistakes that investors make. (Terrence Odean, who has done a number of fascinating studies on investor behavior, published a paper, Are Investors Reluctant to Realize Their Losses?, which shows that investors are twice as likely to sell their winners as their losers.)

Losing money on a stock -- even if only on paper -- is painful thing. (Those of you who have read my columns on American Power Conversion (Nasdaq: APCC) know that I speak from personal experience.) This pain can trigger irrational, destructive decisions, especially among less-experienced investors. Millions of people were lured into picking stocks for the first time over the past year or two by the false promise of easy riches. Until recently, they had known nothing but a euphoric bull market, but many are now sitting on losses of 50%, 80%, or more in certain stocks. Uncertainty, fear, and even panic are the widespread consequence. It is absolutely critical during times like these to be supremely rational when making investment decisions.

Why investors cling to mistakes
Even the most successful investors make mistakes. What generally differentiates them from the rest of the pack is that they minimize the number of mistakes and, equally importantly, quickly recognize, acknowledge, and sell mistakes. Regarding the latter, you would think that once investors had come to realize that they had made a mistake in buying a stock, then selling would be a natural next step. Unfortunately, this is often not the case, especially when it involves selling at a loss. Why? Forty-two years ago in his timeless classic, Common Stocks and Uncommon Profits, Philip Fisher nailed the answer on the head:

"There is a complicating factor that makes the handling of investment mistakes more difficult. This is the ego in each of us. None of us likes to admit to himself that he has been wrong. If we have made a mistake in buying a stock but can sell the stock at a small profit, we have somehow lost any sense of having been foolish. On the other hand, if we sell at a small loss we are quite unhappy about the whole matter. This reaction, while completely natural and normal, is probably one of the most dangerous in which we can indulge ourselves in the entire investment process. More money has probably been lost by investors holding a stock they really did not want until they could 'at least come out even' than from any other single reason. If to these actual losses are added the profits that might have been made through the proper reinvestment of these funds if such reinvestment had been made when the mistake was first realized, the cost of self-indulgence becomes truly tremendous."

This sentence bears repeating: "More money has probably been lost by investors holding a stock they really did not want until they could 'at least come out even' than from any other single reason." Don't fall victim to this trap! As my friend says: "Don't let what you want change what is. You don't have to make it back the same way you lost it."

Thinking rationally
Now that we understand that it is normal to irrationally resist selling a losing stock, how can we reorient our thinking? Here's how I do it: In my mind, I assume that my entire portfolio is 100% cash. Then I ask myself, "How would I invest this cash? Which stocks would I buy? What would my new built-from-scratch portfolio look like?"

I urge you to do the same mental exercise. Now compare your hypothetical new portfolio with your current one. Is it different? Are there any stocks in your current portfolio that you wouldn't buy today if you had 100% cash? If so, then why on earth don't you sell them immediately?

One good answer is that you are sitting on a big capital gain and don't want to pay the taxes. That's a good reason, as taxes are a real cost. (It's an especially good reason near the end of the year, when by delaying selling by less than a month, you can defer paying the taxes for an entire year.) Let's say you were lucky enough to buy Cisco (Nasdaq: CSCO) at its IPO, meaning that your cost basis is a few pennies per share. If you sold at $50, you would have to pay $10/share in taxes assuming the 20% long-term capital gains tax rate. That means you would be trading $50 of Cisco for $40 of another stock. Do you have that much confidence in another stock (or, conversely, are you quite certain that Cisco's stock will decline)? While I'm a proponent of long-term investing, if you're confident that the answer to either of these questions is yes, then sell.

The decision to sell should be much easier if you have a loss on a stock (assuming, as noted above, that you would not buy the stock today if you didn't own it). Think of it this way: Uncle Sam is paying you to sell! Losing money on a stock is no fun, but a tax loss can soothe the pain a bit.

Conclusion
As I've written in many previous columns, the price you pay for a stock is a critical determinant of your return. But once you own a stock, your purchase price is irrelevant to your decision whether to buy, sell, or continue holding -- other than to consider taxes.

Let me be very clear: I am not advocating that you blindly sell your losing stocks. That would be falling into another trap that studies have identified: investors have a terrible habit of buying at the top and selling at the bottom. In fact, all other things being equal, you should be an even more eager buyer at a lower price, since the best time to buy is when the stock of a good company has been beaten down due to external or short-term issues.

Ah, but all other things aren't always equal. Companies and industries change. New information surfaces. Assumptions can prove to be inaccurate. Stocks often decline for very good reasons, and you might be correct in concluding that there are better places for your capital, even though the stock has become cheaper. The key is figuring out which stocks are mistakes and which represent opportunity. That's not easy, but it is certainly much easier if you can overcome the natural human tendency to irrationality cling to losing stocks.

-- Whitney Tilson

Whitney Tilson is Managing Partner of Tilson Capital Partners, LLC, a New York City-based money management firm. Mr. Tilson appreciates your feedback at Tilson@Tilsonfunds.com. To read his previous columns for the Motley Fool and other writings, click here.