Not Selling Can Have a Cost

Imagine if somebody came at night and sold everything you own. Then ask yourself, if you had nothing, what would you own?

This is an exercise that Dan Ariely, a professor of psychology and behavioral economics at Duke University, suggested engaging in when we spoke several years ago. I came across the edited transcript of our conversation while digging through our archives of content. Ariely said he used this exercise to show how individuals often become attached to their possessions (including investments) and find it hard to part with what they own.

Selling remains one of the toughest decisions for investors, both individual and institutional. A variety of behavioral biases leads us to make mistakes when selling. While much focus is placed on the buy decision, the sell decision can be one where bigger mistakes are made.

Among those mistakes is opportunity cost. Opportunity cost is the benefit forfeited by not allocating resources elsewhere. In terms of investing, opportunity cost is the higher return you miss out on by not switching to a better stock, bond or fund. Though it is only truly apparent with hindsight given the unpredictability of individual security and fund returns, we can assess whether a different stock, bond or fund has better potential going forward than the one we own now.

Opportunity costs commonly stem from investors’ unwillingness to part with investments currently held in their portfolios. We assign more value to what we currently own relative to what we don’t. Familiarity with what we own provides a sense of comfort relative to an investment we’re not as familiar with or don’t currently own.

As investors, we also don’t like missing out on what we perceive as potential upside, especially if selling currently would cause us to recognize a loss. Rather, our biases can lead us to view bad news as a temporary occurrence. Sometimes a bad earnings report is truly a temporary hiccup for an otherwise good business trading at an attractive or fair valuation. Other times, bad news is a sign of something having worsened.

All of this gets amplified when someone buys an investment with the intention of realizing a short-term gain only to see it go in the other direction. In such instances, a short-term trade can turn into a long-term investment as an investor holds out hope that it is just a paper loss and that if they wait, the stock price will make a comeback.

The problem with changing your rationale for holding onto an investment after purchase rather than changing what you actually own is the potential loss of the return you could realize by allocating your money elsewhere. Seeing an investment recoup its loss may be emotionally satisfying, but it may not make economic sense if an alternative investment you could have identified and switched to realizes an even greater return over the same time period.

This does not mean you should be quick to sell. Selling too often results in unnecessary transaction costs (including potential tax expenses) and creates the risk of buying investments with worse future returns than the investments you sold. Rather, the threat of opportunity cost is a reason to have a strategy in place for evaluating your investments in a rational manner. At AAII, we follow prewritten sell rules for all of our model portfolios. These rules take the emotional component out of the decision to sell or not, and thereby keep our management process disciplined.

Keep in mind that the decision to sell will not always be clear cut. An investment can violate the spirit of your strategy, but not directly violate one of your specific sell rules. In such instances, you will have to make a judgment call. When this occurs, asking yourself if you would buy the investment now if you didn’t already own it can be a very helpful exercise.