Calibrating Selling – A rich source of additional alpha

Background

Portfolio managers generally have an explicit selling discipline, often the direct opposite of their method for selecting buys. Reversing the process used to choose buys as a means of identifying sells has tremendous intuitive appeal. In practice, however, there is more to how sell decisions are actually made, some of which is unrecognized and unmanaged.

In a recent survey, professional investors acknowledged that they also rely on judgment to shape their sell decisions. Respondents to the survey conducted by Cabot Research and the CFA Institute overwhelmingly chose observation and a sense of “knowing what to do” over more quantitative or research driven sell practices. Mounting research suggests that most managers can quickly improve portfolio performance by implementing small refinements to their sell disciplines that reduce a reliance on untested, behaviorally influenced decisions.

Judgment, Behaviors and Measurement

Judgment often provides the extra performance that puts your portfolio into the top quartile. This boost to performance, however, is available only when judgments are calibrated. Absent quantitative calibration, judgment is highly susceptible to behavioral influences.

By its very nature, judgment requires tremendous support from our unconscious brain. This is the portion of the brain where heuristics, beliefs and all rapid decision making resides. Research involving professionally managed equity portfolios indicates that all managers engage in uncalibrated sell decisions at some level. This finding is equally observed in funds managed by classic "stock pickers" as well as when sell decisions are driven by quantitative signals. Research also suggests that small shifts in sell behaviors can predictably result in 100 basis points or more of incremental performance.

Can You Quantify the Value of Your Judgments?

In general, improving a skill involves measuring results. Harnessing the most from your selling requires an objective understanding of how your sell decisions add value. If like most professional managers you invest the lion’s share of resources into buy decisions... quite likely then, you can capture more of the alpha generated in your buys by reexamining your sell discipline.

Survey Results

Participants in the Cabot survey were asked four questions about their selling practices. Here is a summary of what they said.

Q1. Which best describes your approach to selling?

Slightly more than 81% indicated that judgment plays a substantial role in their sell decisions. In contrast, only 29% said their sell decisions are "Highly disciplined, driven by research and objective criteria."

Q2. How did your selling discipline develop?

Just 28% of respondents mentioned extensive research and back-testing helping them learn to sell. On the other hand, over 70% indicated that experience, trial and error, and advice from past mentors shaped their sell processes. Interestingly, 20% learned to sell by "observing what works and what doesn't."

Q3. What informs you that your sell discipline is working?

Approximately 60% of survey respondents said that they gauge the success of their selling from portfolio returns. Only 16% indicated that they attempt to separately quantify selling effectiveness.

Q4. Which discipline most often results in your selling a stock?

Participants were divided between "knowing the right time to sell" and "selling by-the-numbers and research." The relatively high proportion responding that they sell "by-the-numbers" does not jibe with the frequent use of judgment observed in the answers to Questions 1, 2 and 3. This apparent inconsistency might be explained behaviorally in that individuals often intend to do one thing (Explicit Theory) while in the moment do something quite different (Theory-In-Practice).

References:
1. The Survey of Professional Investors' Sell Discipline Conducted by the CFA Institute and Cabot Research, Cabot Research LLC, June 2007.
2. Sell Discipline and Institutional Money Management, WORKING PAPER SERIES Paper #1, By: Christophe Faugère Hany, A. Shawky, David M. Smith, The Center for Institutional Investment Management, University at Albany June 2003.