Bearing up in a Bear Market

Nathan Rothschild the 19th Century London financier is credited with having said "The time to buy is when blood is running in the streets." And, as this maxim suggests, the current market turmoil can present equity managers with extraordinary buying opportunities. Capitalizing on such buying opportunities, however, generally requires managers to create liquidity within their portfolios – and that means knowing what to sell.

Selling, as has been discussed in our previous essays, is prone to behavioral influences. Research suggests that behaviorally motivated sell decisions increase when experiencing under-performance or riding out a turbulent market. A few ideas to help you check your own behavioral tendencies during these times are presented below.

Question yesterday's answers

No one likes being wrong, particularly publicly. Holding on to positions with unrealized losses ("losers") can be encouraged unintentionally by maintaining a "full value" price for a stock based on old or faulty information. Anchoring, as this tendency is known, can be exhibited by analysts or managers or both. Challenging yesterday's assumptions and conclusions can help avoid anchoring.

No pain, no gain

Managers sometimes engage in elaborate self deceptions to maintain losing positions in the portfolio. The most common rationalization for holding on to losers involves the expectation for a near-term rebound. Loss Aversion, a behavior known to stifle the selling of losers, stems from our desire to avoid locking in a loss and subsequently feeling bad about our decision to own the stock in the first place. Extensive research performed by Cabot indicates that professional managers often fall into the trap of Loss Aversion - at least with regards to certain positions - and that correcting this behavior can lead to significant improvement in performance.

Tossing the baby out with the bath water

Managers need to safeguard against the desire to reconstitute the portfolio and place all the bad news behind them precipitously. On the surface this approach can seem entirely economically motivated. The familiar mantra of "If you wouldn't buy it today at today's price then you should be a seller" comes to mind as a strong defense for "clearing the decks." Overreaction when below the benchmark, however, is a well documented behavior. It reflects elements of Prospect Theory wherein people prefer to swallow all their bad news at once, while savoring their good news in little bites – for emotional rather than economic reasons. Maintaining your cool under siege and carefully reevaluating each position in the portfolio can go a long way towards avoiding this type of costly over reaction.

Selling with a rear-view mirror

Selling is often backward looking in that past performance influences which positions are sold and which are held. Overcoming the strong desire to sell a position that is down significantly -- regardless of its future prospects – is part of what separates a careful sell discipline from "rules-of-thumb." Marketing demands can conspire to accentuate unconscious perceptions about a stock. This can lead to holding recent winners too long so that they can be discussed with prospects as representative holdings; or jettisoning recent losers so they don't have to be discussed. Whether guarding against holding on to "show dogs" or engaging in "window dressing" managers need to exercise added vigilance in evaluating their sells in today's raucous market.

Good experiences can lead to poor learning

It is from the careful analysis of our experiences that the most important lessons are learned – not merely having had the experience. In their paper "Once Burned, Twice Shy", Terrence Odean, Strahilevitz and Barber describe that investors may avoid specific stocks now or in the future simply because they previously sold them for a loss. In these instances investors appear confused between price volatility and fundamentals or their earlier judgments and the go-forward prospects for the stock. Such inappropriate lessons are referred to as counterfactuals and can easily exists when a manager's reflections about events goes uncalibrated. The challenge for managers is to learn the correct lessons from experience and this usually requires both (i) the perspective gained from time coupled with (ii) an objective, analytical review of what really happened. Consequently, the midst of a wrenching market may not be the right environment in which to refine your strategy.

References:
1. Terrance Odean, Michal Strahilevitz and Brad M. Barber, "Once Burned, Twice Shy: How Naive Learning and Counterfactuals Affect the Repurchase of Stocks Previously Sold.", Working Paper, September 2004, Available at SSRN.
2. Behavioral Matters, Volume 1 – "Calibrating Selling – A rich source of additional alpha", December 2007; and Volume 2 – "Sell Like You Buy – Strategically", January 2008.
3. "Getting the sell discipline right" May 15, 2007, Citywire Financial Publishers, www.citywire.co.uk.