If In Doubt, Sell Half

Foreword from ShareInvestor

This article “If In Doubt, Sell Half” by Goh Eng Yeow was first published in The Straits Times on 18 May 2014 and is reproduced in this blog in its entirety.

Advice for investors torn between taking profit and cutting loss when stock prices fluctuate

As a financial writer, I regularly get queries from readers about their investment strategies but while they might sound innocuous, they often defy straight-forward answers.

Take this from Mr Lawrence Law, a 58-year old Singaporean working in Jakarta who got into share investing only late in life.

Mr Law bought 2,000 Singapore Airlines shares in two tranches but the average cost was below the carrier’s market price. He asked if he should sell the 1,000 shares that were profitable, while keeping the other 1,000 that were still below his investment costs.

Well, the answer will depend on what sort of investor he is.

If he is a “buy and hold” person like me, he will probably not do anything as he would have studied the counter very carefully before investing and would settle in for the long haul.

This is the approach so elegantly elucidated by investment guru Benjamin Graham, who noted that in the short run, the market behaves like a voting machine – tallying up which firms are popular and unpopular. But in the long run, it is a weighing machine, assessing whether a company’s business has substance.

But herein lies the problem: There are times when a company is unloved, for whatever reason, even though it enjoys good business fundamentals. This is reflected by its depressed share price.

It may take a long time before it is priced correctly, yet in the meantime, it can be frustrating and painful for investors who are right about the company at the wrong time.

One example is beverage giant Fraser & Neave, whose share price had traded for years at a so-called “conglomerate” discount to the value of all its various businesses when they were added up.

The shares finally received a boost nearly two years ago when it became the subject of a fierce takeover tussle that resulted in Thai billionaire Charoen Sirivadhanabhakdi taking control.

So for many investors, it may be the tallying of votes – what other people think of the stock – that matters a lot more than the weighing machine Mr Graham talked about.

There is another analogy for investors who take a much shorter view on their investments, one enunciated by another great investor, the British economist John Maynard Keynes.

He described investment as a beauty contest with a difference. To guess the winner, what is important is not to select who you believe to be the most beautiful contestant but to guess at how the judges will rate the various contestants.

Seen in that light, successful investing is really a lot more psychology than anything else, a process of coming to grips with your own emotions as well as others’.

My answer to any investor, who is confronted with a dilemma over taking profit on his winning bet or cutting loss on a plunging stock, is to sell half of it.

Selling half of the investment will release the psychological logjam that comes from trying to decide whether to keep the investment or get rid of it completely. He can then analyse why he bought the stock in the first place, and whether to hold the remaining shares, sell them or buy more.

This ploy is especially useful to a trader who is facing losses on his bets. What should he do if he keeps losing money even though he believes he is right and that the market would see sense eventually?

When a stock falls substantially, the trader’s first reaction is denial, as he hopes to salvage the best of a bad situation, telling himself that it is only a short-term fall.

Then when it drops further, he may start calculating how much money he has lost. He may even hold the stock for a while longer, and then when it hits bottom, sell everything and swear never to invest in shares again.

But selling half of the investment first saves him from an even bigger loss if the price continues to plunge. But he will also be able to enjoy some of the investment’s upside if the price recovers.

Once a trader has crystallised his loss, the next step is to look ahead and not dwell on the past, wallowing in despair over how awful it must feel to throw such a huge wad of money down the drain.

Let’s face it, no matter how successful we are as investors, all of us have encountered disasters at one time or another. In his latest newsletter to shareholders of his company, Berkshire Hathaway, investment legend Warren Buffett owned up to losing a whopping US$873 million ($1.1 billion) on the debts issued by a firm known as Energy Future Holdings.

“Most of you have never heard of Energy Future Holdings. Consider yourself lucky; I certainly wish I hadn’t… Unless natural gas prices soar, EFH will almost certainly file for bankruptcy in 2014,” he wrote.

The rest of us would not have $1 billion to lose in the first place. But in acknowledging his investment mistakes, Mr Buffett flags the importance of learning from them and moving on. That is a valuable lesson for all of us.