FOOL ON THE HILL

Don't Sell at the Bottom

Investors often panic and sell at precisely the wrong time. Whitney Tilson offers some advice on how to avoid this extremely annoying -- not to mention financially painful -- phenomenon.

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By Whitney Tilson
November 6, 2002

In my last column, I wrote about investors' unshakable habit of piling into the hottest investment fad at precisely the wrong time. Today, I warn about the opposite, yet equally pernicious, habit: panicking and selling at the bottom.

How many times have you bought a stock or invested in a mutual fund, watched it decline, sold because you couldn't take the pain anymore, and then watched it rebound? It happens all the time, and I'd wager there's not a single investor who hasn't been victimized by this extremely annoying -- not to mention financially painful -- phenomenon.

With such a broad-based decline in the market (unlike last year), there have been few places to hide in 2002, as the great majority of stocks and funds have fallen significantly. If your portfolio has gotten whacked, what should you do? Dump the investments after they've fallen, or hang on in the hope that they'll rebound? I've found this to be the most difficult type of investment decision: distinguishing between genuinely lousy investments that will never bounce back (and thus should be sold immediately) and those that have been unfairly beaten up by the market and should therefore be held or even bought.

Warren Buffett, as always, has great advice. In an interview in the latest issue of Fortune, he was asked if it bothered him that many believed "you were a has-been, that you were through" when Berkshire Hathaway's stock -- and those of many of Buffett's holdings -- were getting pounded during the Internet bubble.

Buffett replied: "Never. Nothing bothers me like that. You can't do well in investments unless you think independently. And the truth is, you're neither right nor wrong because people agree with you. You're right because your facts and your reasoning are right. In the end, that's all that counts. And there wasn't any question about the facts or reasoning being correct."

In other words, to be a successful investor, you must ignore the market and the false signals that it can send out, and instead rely on "your facts and your reasoning" -- nothing else. This advice is undoubtedly correct, but it can be hard to apply in practice.

Evaluating stocks
For example, let's say you bought AOL Time Warner (NYSE: AOL) and Tyco (NYSE: TYC) a year ago at $33 and $49, respectively. Now, at $15 and change each, they're down 52% and 69%. What should you do?

I don't have a strong opinion on either of these stocks, and that's OK, since I don't own either of them. I do, however, have an opinion (and obviously a favorable one) for every stock I own -- and you should too. As I wrote in Never Too Late to Sell:

You should calmly and unemotionally evaluate every one of your holdings. Are there any in which you have lost confidence, or in which you still believe, but think the valuation is too high? Then think very hard about selling. The key question that I ask myself is: 'If I didn't own this stock, would I buy it today?' If not -- and if there are no taxable gains -- then I will usually sell.

As you review your portfolio, keep in mind that a stock doesn't know that you own it. Its feelings won't be hurt if you sell it, nor does it feel any obligation to rise to the price at which you bought it so that you can exit with your investment -- not to mention your dignity -- intact.

Evaluating investment funds
The same principles apply when evaluating investment funds. If you simply look at performance, especially over a short period in such a turbulent market, you are likely to make a bad decision.

Consider what happened to three of the greatest investors of all time during the early 1970s -- the last period in which the U.S. stock market experienced a bubble and subsequent decline comparable to recent history. From 1970 to 1972, investors piled into a handful of premiere growth stocks, labeled The Nifty Fifty, which (at their peak) traded at an average P/E ratio of 42 versus the S&P 500's 19. Then the bubble burst, and in 1973 and 1974, the Dow fell 33.2% (44.4% from peak to trough).

Warren Buffett (who made Berkshire Hathaway (NYSE: BRK.A) his investment vehicle after closing his partnership at the end of 1969), Charlie Munger (who had not yet formally teamed up with Buffett and was running his own partnership), and the Sequoia Fund's (Nasdaq: SEQUX) Bill Ruane all experienced the worst relative and absolute investment performances of their otherwise-spectacular careers during this period. Here's the data:

Yr    S&P 500   Berkshire   Munger   Sequoia
1970     3.9%       -7.1%    -0.1%       n/a

1971
14.6% 79.5% 20.6% 13.5% 1972 18.9% 14.3% 7.3% 3.7% 1973 -14.8% -11.3% -31.9% -24.0% 1974 -26.6% -43.7% -31.5% -15.7% TOTAL -11.5% -4.8% -39.7% -24.6%

Note: Berkshire Hathaway's returns are based on year-ending share prices. The Munger Partnership's returns are net to limited partners. The Sequoia Fund was launched on July 15, 1970, and appreciated by 12.1% over the balance of the year, trailing the 20.6% return of the S&P 500 over the same period.

Imagine that you had encountered Warren Buffett at the end of 1975. Impressed with his intellect and investment approach, you would have naturally examined his track record -- and almost certainly, to your everlasting regret, not invested. Why? Because his results, as measured by the stock price of Berkshire Hathaway, were truly dreadful over a four-year period. The stock not only declined and trailed the market during the 1973-74 downturn, but also in the 1975 rebound. Consider this data:

Yr    S&P 500  Berkshire
1972    18.9%      14.3%
1973   -14.8%     -11.3%
1974   -26.6%     -43.7%
1975    37.2%      -5.0%
TOTAL    2.0%     -45.8%

The rest is, of course, history. From $38/share at the end of 1975, Berkshire Hathaway has risen nearly 2,000 times to yesterday's closing price of $73,900. [For more information about the track records of these investors (and many others), plus some of the wisest words ever spoken about investing, see Buffett's famous 1984 speech, The Superinvestors of Graham-and-Doddsville.]

My point is not that you should ignore performance -- it's that you should evaluate money managers based on two things, neither of which has anything to do with short-term investment returns. First, consider their investment approach, and second, their ability to carry out that approach successfully (assuming, of course, that the manager has the requisite integrity).

Conclusion
Countless studies have shown that during turbulent times like these, investors are prone to making hasty, irrational financial decisions. Don't let this happen to you! Now, more than ever, you must block out your emotions and be supremely analytical in evaluating your holdings and making investment decisions.

Guest columnist Whitney Tilson is managing partner of Tilson Capital Partners, LLC, a New York City-based money-management firm. He owned shares of Berkshire Hathaway at the time of publication. Mr. Tilson appreciates your feedback on the Fool on the Hill discussion board or at Tilson@Tilsonfunds.com. The Motley Fool is investors writing for investors.