Picking stocks is only half the battle. How can you know when to sell? Just like buying a stock, a sell decision should be attacked top down. The first and easiest answer for when to sell is if you fathom the likeliest market scenario over the next year is down a lot. Then, selling most of your stocks is good—but also rare. What about in between true bear markets? How do you know when to cut and run?
The answer is: You have used the Three Questions and discovered something fundamental has changed about why you hold a stock. For example, after a fairly flat yield curve, the yield curve suddenly gets steep. You might decide to pare back your growth stocks in favor of more value stocks.
If you think firms with elastic demand (Tech, Consumer Discretionary) will do better than those with inelastic (Health Care, Consumer Staples), you can change your weights—necessitating the sale of some stocks. Or maybe you fathom some other economic, political or sentiment force impacting a certain sector or industry. For instance, you know Congress will enact yet more accounting restrictions which you (and few others) fathom will harm Financials. Or maybe, after a lengthy period of high-dividend stocks outperforming, everyone is deliriously enthusiastic about Utilities, so you somehow know it’s time to underweight Utilities shifting to non-dividend-paying stocks. Mind you, this doesn’t mean the stocks you sell are bad. They just don’t fit what you now need as a result of using the Three Questions—you need stocks that represent your asset and sub-asset allocation decisions.
Lock and Load
What about if a stock has been up a lot? Shouldn’t you sell and “lock in profits”? I never really understood how people “lock in profits.” I think this is something people say a lot without thinking it through. Lock in profits how? The gains you take from a stock that is up don’t get locked in a vault somewhere. You reinvest those dollars (don’t you?), and the stocks you buy with “gains” you’ve “locked in” aren’t guaranteed to only rise. The next stock you buy may fall, erasing profits an investor thinks are “locked in,” which means paying taxes on the gain from the first stock and still losing money on the second. There is no such thing as “locking in profits.”
Don’t sell to “lock in profits.” Sell to get out, pare back a weight you need to reduce or because in your view the stock no longer is more likely to best its category whose effect you need in your portfolio.
And just because a stock is up a lot doesn’t mean it can’t keep rising. It happens all the time. Remember, stocks aren’t serially correlated—they have a 50/50 chance of continuing in the prior direction or reversing course. Continue holding a stock that is up if the fundamentals that led you to hold the stock remain intact.
When to Sell?
What about when a stock is down a lot? Shouldn’t you cut the dogs, take the loss, offset taxable gains and go your way? Maybe, maybe not.
First of all, why is it down a lot? Is it because the entire market is having a correction, and it’s just doing what the market is doing? If so, it probably doesn’t make sense to cut and run. Relative return is what matters, not absolute return (usually). Is it down because the stock’s sector or category is down—either because the sector is correcting (sectors correct, too) or because it’s out of favor? Is it down because the stock is part of your counterstrategy? That stock is behaving as a counterstrategy stock should—also not necessarily a reason to cut. (Focusing on one stock’s performance or one sector’s performance instead of how the whole portfolio is performing is order preference—a cognitive error you use Question Three to combat.) Is the stock down because some horrendous news surfaced? The CEO cooked the books, they hosted lavish Greek-themed parties on the shareholders’ dime or some other rumor—believable or outrageous—surfaces?
The fact of the matter is, by the time the bad news has come out, the market may have already responded, and you’ve likely missed the chance to avoid the big drop. Now, you can sell at the absolute lowest and take your dough and move on, but that is buying high and selling low. And the stock where you reinvest isn’t guaranteed to only go up. It might drop, too, and now you are super wrong but twice. There is still a 50/50 chance the prior direction continues—or reverses.
Don’t sell as a knee-jerk reaction to a big drop. Instead, look at the company as we did when we were buying. Ignore the hype because that is past and you can’t do anything about it, and look for what you can fathom that others can’t. Is the “bad news” such that the company can recover from it? Is the company essentially sound?
Also, deeply consider if the bad news is correct or credible. Not to put too fine a point on it, but frequently journalists, in the rush to get the story first, don’t have the story straight. Often what they report is overblown or simply wrong. They may not have a background in the firm they’re reporting on. In fact, they probably don’t! Something routine can easily be misinterpreted or blown up to sound ground-shaking. Or a minor infraction not material to the firm’s core business may get the misinformed full-court press. Or journalists may be going on the hearsay of a disgruntled employee without doing further fact checking. Or they may overlook something truly material, because they don’t deeply understand the firm’s core business. Happens all the time! Journalists frequently get their news very wrong.
If the besieged firm is sound despite the hysteria, the stock may very well rebound, giving you a chance to sell at a relatively higher point later. What’s more, since sentiment will be so poor about a stock that had a sudden and precipitous price drop, any good news, no matter how meager, can drive it up.
What if you’re cool-headed and don’t sell just because everyone else did (good for you), and you take a reasonable look at what is true about why the stock dropped suddenly? What if the bad news truly signals something rotten in Denmark, something even a big management shake-up won’t help, something rotting the core business? Despite the relative low, that’s still a right time to cut your losses, utter a few obloquies and know you simply can’t help it when you get blindsided sometimes. This is why you diversify and never put more than you’re willing to lose in any one stock.
If that makes you diabolically depressed, consider this. If you have a well-managed portfolio, you won’t have much more than a few percent in any stock. If one stock gets halved tomorrow from sudden bad news, maybe you lose 1%. If you think relatively and scale (always!), you can combat order preference and focus on the overall portfolio, not the one, small, imploded position. You lost 1%. In reality, stocks rarely lose 100% of their value fast. You can experience a 10% to 20% individual stock drop, and then the overall impact is minimal. Even a massive drop in one stock should have minimal impact on a well-managed portfolio. Shake it off, accumulate regret, learn what you can for next time and move on. If something fundamental didn’t occur, continue to hang on for now—but keep an eye on any such change.
Here are two examples of a single incident where my firm made two different choices on fairly similar stocks—one to sell and one to hold. (This is the exact example I used in 2006, but the lesson is still very valid now.)
On October 14, 2004, Eliot Spitzer, then Attorney General of New York State (before he was governor and before he was the disgraced governor), decided Hank Greenberg, then CEO of AIG, was guilty of . . . something.11 (I believe there has never been a male member of the Greenberg family Mr. Spitzer doesn’t believe is guilty of something—he’s pretty much gone after all of them one way or another.)
Meanwhile, one of Greenberg’s sons, Jeff, ran another huge public insurance company called Marsh & McLennan (MMC; which also owns the Putnam mutual fund family—which Spitzer attacked heavily the year before). Essentially, Spitzer claimed MMC was guilty of bid-rigging for its insurance contracts and named other insurance companies, including AIG, as being complicit. Later, Spitzer very publicly accused AIG and, indeed, Hank Greenberg of being party to the alleged misdeeds. Along the way, MMC’s board, under attack from Spitzer, forced out Jeff Greenberg. Then AIG’s board, also likely wary of Spitzer’s force and power, forced Hank Greenberg out. Eventually, the charges against AIG were dropped, and MMC settled.
Meanwhile, Spitzer and Hank Greenberg had it out in the press, and some of Greenberg’s friends got involved, including former Goldman Sachs CEO, John Whitehead, whom Spitzer may or may not have threatened with both bodily and professional harm—depending on whose version you believe.
Markets hate surprises, particularly surprises involving the AG of NY. Both stocks fell immediately on the news—AIG was down −10% on October 14, 2004, and MMC was down a big −24%.12 What to do?
Avoiding the drop ahead of time would have been nearly impossible. There was no way to know Spitzer was planning this—not unless you had special and illegal insight into his intent. When such a market event occurs, you especially need Question Three. Sudden drops in stock prices get loss aversion working full throttle. Selling out after a big drop sometimes makes sense, sometimes is epically stupid—and you won’t know which is which until later, and you won’t get any appropriate cues from the market or the New York Times.
I was bullish on the finance sector then and insurance specifically. Everything about both stocks was right, category-wise. The only reason to sell a stock fitting my bigger portfolio themes was if something was rotten individually about it. Now, I’d met Hank Greenberg a couple of times. And while he can be abrasive at times, sort of like me, he was a phenomenal CEO for a very, very long time. Truly phenomenal, and I couldn’t believe he had actually done anything very wrong because he didn’t need to. (Basic rule: The most capable people don’t need to break rules and won’t.) On the other hand, he was 80, so he couldn’t be phenomenal for long.
But I also had no idea Spitzer would later in 2005 quietly excuse Greenberg of any criminal wrongdoing (announced during Thanksgiving week, no less, where news items go to die.13 If you want to bury a news release, announce it over Thanksgiving, Christmas, Easter or the Fourth—far fewer folks will ever see it). I knew—everyone knew—AIG was a massive company with well-diversified product lines. I understood the crime of which AIG stood accused, but I couldn’t see how it would impact the long-term health of AIG overall—it wasn’t a big enough crime. If it turned out something was wrong with the business group involved with the alleged bid-rigging, AIG could easily spin off the group, rout the evildoers or otherwise cut out the (alleged) cancer. I couldn’t see any reason why the rest of AIG should be infected at the time. Also, there was speculation of Greenberg stepping down, and though Greenberg built AIG into what it was, at 80, his departure couldn’t hurt too much. What’s more, his leaving could please the market and take heat off the stock. Finally, because there was so much dour sentiment about AIG, any bad news was pretty well priced—so I could fathom any good news, no matter how weak, would be a pleasant, bullish surprise. I opted to hang onto AIG.
The story was different for MMC. MMC stood accused of flim-flammery in its main business line and core competency. The case seemed stronger. To survive, MMC would have to navigate at least one major lawsuit, with possible copycat suits from other states. It would likely do a strategic reboot, cast off a number of its upper management and generally be in a major state of disarray for months, if not years. But that was small.
The new CEO MMC brought in, Michael Cherkasky, a perfectly fine fellow, was the CEO of Kroll, a public company specializing in corporate security work that MMC bought the year before. Cherkasky was picked as CEO not because he was the optimal guy to run a big insurance firm, having extensive background and success in insurance. He didn’t have that. He was picked because he had a prior background as a regulator and had worked with Eliot Spitzer before, and it was presumed Cherkasky could get along with Spitzer. To me, this was all wrong and bad. Cherkasky’s prime experience as a CEO was at Kroll—a little firm, smaller than my firm. I know something for sure: I’m certainly not qualified to be CEO of something the size of MMC. Said otherwise, I’m fully as qualified to be CEO of MMC as Cherkasky was because, while I’m no insurance guy, at least I’m a financial services guy, and Cherkasky was neither an insurance nor financial services guy and hadn’t been CEO of anything nearly the scale necessary to be truly qualified to run MMC’s far-flung diversified operations. I knew if I couldn’t run it well, he couldn’t. So, my firm decided to take our double-digit loss and sell.
I’m sure many folks would, initially, view that as an odd decision. Why sell one and not the other? Aren’t they cut from the same cloth? Wasn’t Spitzer gunning for them both? Shouldn’t we cut the dogs and buy some winners? That sounds great in theory, but we all know the stocks you buy to replace your dogs may be woofers themselves. Never sell a stock because it’s down. Sell because something fundamental has changed about the reason you hold it. Think about that funnel again and the fundamental reasons, top down, why you might sell. The fundamental reason could be that you forecast a down-a-lot scenario, and you’re shifting largely out of stocks. It could be you’re shifting from growth to value, small to large or the reverse. Your sector outlook may have changed, and you need to move from an overweight to an underweight. Maybe you’re dangerously overweighted because the stock has appreciated far beyond 2% or 3% of your total holdings. Or maybe you wake up to discover the company has done something illegal from which recovery will be either lengthy or impossible.
When Spitzer formally subpoenaed AIG in February 2005, the stock had another stomach-churning drop—over 31% to a relative low in April. Nothing had changed since October of the previous year except increased fear of Spitzer, so we hung on. Based on some larger portfolio themes, we finally sold AIG in January 2006, after it rallied 42% from its low in 2005, for a 19% net gain from October 14, 2004, when its woes began.14 We couldn’t guarantee anything else bought with the proceeds from a sale on October 14 would have been up 19%—AIG did about as well as the S&P 500 over the same time period. When we sold AIG, MMC was still down more than 3% from when the news hit and lagging its category big time. Still, I felt pretty good about not panicking and selling AIG when it was in a huge hole. (This is interesting looking back now because many feel AIG could have avoided the mess it later got into that culminated in its 2008 partial nationalization had Greenberg remained at the helm and not been chased out by a politician looking to curry favor.)
Remind yourself you aren’t collecting a bunch of high-flying stocks. You aren’t a stock collector. Stock collectors are hamstrung by order preference and overconfidence and focus on the two stocks that did well and forget about how their whole portfolio is doing, not to mention risk management. Your aim should absolutely not be to find the next hot stock you can brag about to your poker group (or yoga class or, worse, tofu-tasting party). Rather, you’re maximizing the likelihood of beating your benchmark. You need stocks that act like the components of your benchmark. That is what this exercise is about.
With that, you have a strategy to keep you disciplined—a strategy requiring constant application of the Three Questions. Garnering market-like return when your Stone Age brain wants to cave to TGH so very badly and either hit homeruns daily or cower with a few CDs and money market funds is quite an accomplishment. But I want you to aspire to more. I want you to be disciplined with a strategy. I want you to advance the science of capital markets technology and be among those who can move down the learning curve faster. I want you to master the Three Questions and use them always. I want you to stick it to The Great Humiliator. Stick it to him hard.
Notes
1. Kenneth L. Fisher and Meir Statman, “The Mean Variance Optimization Puzzle: Security Portfolios and Food Portfolios,” Financial Analysts Journal (July/August 1997), pp. 41–50.
2. Global Financial Data, Inc., S&P 500 total return for US stocks; USA 10-year Government Bond Total Return Index from 12/31/1925 to 12/31/2010.
3. See note 2.
4. See note 2.
5. Morgan Stanley Capital International as of September 30, 2011.
6. Thomson Reuters, technology as measured by the Nasdaq 100 Index, health care as measured by the S&P 500 Pharmaceuticals Index, which is now discontinued. Standard deviations are of each index, 50/50 portfolio and standard deviation derived by combining both tech and health care indices and rebalancing each year.
7. Thomson Reuters, Merck and GlaxoSmithKline return from 12/31/1989 to 12/31/1999.
8. Kenneth L. Fisher, “Give It Time,” Forbes (January 31, 2005), p. 142.
9. Thomson Reuters, Flowserve return from 12/31/2004 to 12/31/2005; MSCI Industrials net return from 12/31/2004 to 12/31/2005, S&P 500 total return from 12/31/2004 to 12/31/2005, MSCI World Index net return from 12/31/2004 to 12/31/2005.
10. Thomson Reuters, JLG Industries and Joy Global return from 12/31/2004 to 12/31/2005.
11. Office of New York State Attorney General Eliot Spitzer, press release, “Investigation Reveals Widespread Corruption in Insurance Industry” (October 14, 2004).
12. Thomson Reuters, AIG and Marsh McLennan return from 10/13/2004 to 10/14/2004.
13. Ian McDonald and Leslie Scism, “AIG’s ExChief Clears a Hurdle but Faces More,” Wall Street Journal (November 25, 2005).
14. Thomson Reuters, AIG’s total return from 2/11/2004 to 4/22/2005; from 4/22/2005 to 1/11 2006; and from 10/14/2004 to 1/11/2006.