Sell Like You Buy - Strategically

It would be hard to argue that selling is not important. In fact, effective selling is paramount to capturing all the performance provided from buys. Yet, little has been written about this crucial aspect of investing. In a highly referenced paper, Faugère, Shawky and Smith write "The notion of sell discipline has a long history, but the topic has received only occasional mention in the practitioner literature and no attention at all in academic journals."¹

Selling is the subject of considerable discussion and evaluation when it comes to manager selection, despite the paucity of formal research regarding this topic. Accordingly, most funds can point to a clear articulation of their so called sell discipline. While a fixed holding period is the preferred method of selling for some funds, the vast majority of managers mention "events" and "judgment" as key drivers in their sell process.²

Selling the Past

"The act of buying may be more forward looking and the act of selling more backward looking" suggests Professor Terrance Odean.³ He explains the reversal in perspective between buy/sell decisions this way: "Buys have no baggage. A manager picks a buy entirely for what it can deliver to future performance. When choosing a sell, however, the manager is likely to consider the past performance of a position. Which positions are winners or losers (unrealized gains or losses)? Am I trying to manage a tax consequence? And of course there are the behavioral forces of feeling good about locking in a gain and avoiding locking in a loss."

Behavioral Influences

If selling is less understood than buying and tends to be backwards looking, then just how disciplined is it? In summarizing their research, Faugère et al. note "We find evidence that the choice of sell discipline criterion affects portfolio performance." They go on to conclude that "Our results suggest that in rising markets, institutional money managers are likely to achieve better results from less restrictive and more subjective sell discipline criteria..." The message being at once that discipline is important but, by necessity, must be augmented with judgment. It is precisely in the application of judgment where behavioral influences can have their greatest impact on financial decisions. And, the less studied or calibrated those judgments, the stronger the behavioral component.

You Can't Improve What You Don't Measure

So where does that leave managers who desire to improve their selling? According to Jason Zweig, financial writer and author of Your Money and Your Brain, "It's important to understand that the brain is designed to ignore [ineffective selling] so if you don't deliberately seek to measure it you will never be aware of the problem at all."⁴ Any meaningful measures of sell discipline would include: identifying persistent patterns or behaviors within sells, comparing how well sold positions did after sale relative to other positions held, and computing the benefits of shifting a behavior including measures of statistical significance and predictiveness. But simply knowing the potential benefit from change is not sufficient to assure that change will occur. According to Hersh Shefrin, "Situations where people receive quick, clear feedback about the results of their actions are more conducive to [effective change]." This suggests that improving selling requires both knowing what to do based on rigorous quantitative analysis and real-time support to assist with implementation. Research shows that such a strategic approach to selling – involving quantitative analysis and daily support -- can enable managers to add 100 basis points or more of incremental performance, annually.

References:
1. "Sell Discipline and Institutional Money Management", Journal of Portfolio Management, Spring 2004, Christophe Faugère, Hany A. Shawky, David M. Smith, The Center for Institutional Investment Management, University at Albany June 2003.
2. Ibid, The authors present sell criteria used by fund managers to describe their sell disciplines.
3. Terrance Odean is the Willis H. Booth Professor of Banking and Finance at the Haas School of Business at the University of California, Berkeley. Professor Odean also acts as academic advisor to Cabot Research LLC.
4. Mind Games, "Welling@Weeden", an on-line research journal, May 11, 2007, Volume 9, Issue 9, an interview with Jason Zweig regarding his book "Your Money and Your Brain", Simon & Schuster, 2007.
5. Corporate Behavioral Finance, McGraw-Hill, 2007, by Hersh Shefrin.