This Is Why You Don't Sell Your Winners

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.

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.