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When Should You Sell? | 7 comments | Create New Account
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When Should You Sell?
Authored by: martingale on Friday, December 31 2004 @ 05:27 AM EST

Anonymous, I think there are many valid reasons to sell: If you need the money, obviously. If you realize that your portfolio does not match your risk tolerance you might need to rebalance it. If one of your assets (or asset classes) gains or loses so much that your portfolio no longer represents your asset allocation. What I advocate against, on the basis of research, is selling a stock because you think it is a "bad investment".

My statement that money managers (and others) are overall unable to select securities better than randomly is indeed a theory, just like "gravity" and "evolution" are theories: it's a theory that has been well researched and documented over a 50 year period by numerous peer-reviewed studies so that today the evidence for it is absolutely overwhelming. Please see Burton Malkiel's book.

Recently a new theory, behavioral finance, has challenged some of the core tennants of the efficient market hypothesis and have demonstrated that there are several persistent anomalies that cannot be explained by the efficient market hypothesis. For example, there is a short-term momentum effect, the well known january effect, and unexpectedly low returns on volatility sensitive securities, among others. However, none of these effects can be exploited per-security, they all involve buying large numbers of securities and taking advantage of overall averages. Further, rather than refute the EMH they generally tend to modify it through the addition of further factors beyond French & Fama's three factor model. Exploiting most of these market anomalies also requires large funds and sophisticated trading strategies to gain returns only slightly better than that available from a well diversified buy-and-hold approach (eg: buying equal weights of all the top 10% of US stocks and shorting equal weights of the bottom 10% based on returns over the past 11 months. It takes a lot of money to do that.)

For a recent analysis of one of these anomalies see Are Momentum Profits Robust to Trading Costs, Korajczyk and Sadka in the Journal of Finance, June 2004.

As for the history of money managers, here is a thought experiment: If 1500 people flip a coin, about 750 will gets heads. If those winners flip again about 375 will again get heads. After 9 or 10 flips you'll be down to just a couple of "experts" who have some sort of "skill" in getting heads every time--and they'll have a track record to prove it. Here is the question for you: There are tens of thousands of money managers. Every year some of them (less than half) beat the market. After ten years or so how many Peter Lynches would you expect, and how many do we actually have? I would suggest to you that we have about as many Peter Lynches as you would expect, based on random chance. Again see Malkiel's book for a full, detailed analysis backed up with numbers.

One exception would be Warren Buffet. However, Buffet is more of a manager than an investor. When Buffet invests in a company he does not passively sit back to see whether he made a good choice--he actively gets a seat on the board, gets actively involved in the company, shakes things up, and employs sound managerial techniques to help turn the company around. His return, then, can be seen to be as much a product of his managerial skill as his investing "skill".

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