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Know When to Fold 'Em

Sell discipline is tough even for the best managers.

Staying disciplined when it comes to selling is a challenge for any manager, particularly in down markets. But not doing so can cost even a good manager heavily.

In analyzing portfolios of U.S. stocks with combined assets of $200 billion, Boston-based behavioral finance consulting firm Cabot Research found that even top-performing managers who consistently beat their benchmarks may be losing out on more than 100 basis points of alpha — and sometimes as much as 200 basis points — annually because of poor decision making on when and what to sell. “There may be something good or even brilliant in a manager’s buying, yet selling is either [just] okay or undermining performance,” explains Cabot chief executive Michael Ervolini.

In fact, Ervolini says, managers of all types of portfolios — small-cap and large, value and growth — could learn to do a better job of selling. In a survey of 130 mostly U.S.-based professional investors, Cabot and the Charlottesville, Virginia–based CFA Institute found that more than 70 percent had an approach to selling that was not “highly disciplined [or] driven by research and objective criteria,” and that nearly 60 percent chose “observation” and “trial and error” as the basis for their sell decisions. “People spend their time thinking about buying,” Ervolini says. “There are a few rules or heuristics that are used for selling, but the vast majority of people do not have discipline or rigor in how they analyze sells.”

The behavioral biases that can crop up in selling are well known to those familiar with behavioral finance research: selling winners too early to lock in gains, holding on to losers too long to avoid acknowledging losses, overconfidence, risk aversion, hindsight bias. Although some managers may be inclined to one particular behavior, others may alternate among several depending on how the portfolio is performing. Ervolini, whose firm works with managers to identify and counter their behavioral biases, cites the case of one successful large-cap manager who became more risk-averse when the portfolio’s performance exceeded his benchmark and more risk-seeking when it was below — without realizing these shifts were occurring.

David Giroux, co-manager of T. Rowe Price’s U.S. large-cap value strategy, which has $15 billion in assets, explains that he finds it tough to walk away from winners. “Usually you’re selling because the stock has done well, but when things are going up and sentiment is positive, it’s psychologically hard to walk away,” Giroux says. “The things that are green on the screens make you feel good, and the things that are red make you feel bad. Why do you want to sell the thing that makes you feel good and goes up every day?”

Giroux points to drugmaker Merck & Co., previously a top holding of his. It reached almost $62 in January, then fell by a third on bad news concerning the Vytorin anticholesterol drug it markets in partnership with Schering-Plough Corp. Although Giroux had sold the bulk of his position at a nice profit by that point, he wonders if he took on too much risk by waiting until after the stock had risen above the $51 that his fundamental analysis had shown was fair value. “It was hard,” he says. “We probably should have been selling at $52, $53, $54, and we waited for $58, $59 because it is hard to make those decisions.”

In working with Cabot over the past two years, Mariko Gordon, portfolio manager of New York’s Daruma Asset Management, an institutional small-cap value manager with $1 billion in assets, found that her behavior is the opposite of Giroux’s: She tends to sell winners too quickly, and by dumping rapidly rising stocks well in advance of the portfolio’s average three-year holding period, she was giving up significant return. “We were one of Cabot’s guinea pigs,” she says. “We all know that we get in our own way as human beings, and we all have unique ways of getting in our own way.”

Because Daruma’s portfolio has a limited number of holdings (typically 30 to 35 stocks), “we will not let a position be more than 6 percent, and we get twitchy at 5 percent,” Gordon says. “When a stock does very well, we have a normal tendency to take money off the table.” Although sometimes such a trade is necessitated by the mandate of the fund (for example, a stock must be sold when it moves out of small-cap territory or exceeds 6 percent of the portfolio), Gordon found that at times she was succumbing to a habit of selling too fast. Based on its analysis of Daruma’s tendencies, Cabot daily assigns each of the firm’s holdings a “discourage sell” or “favored sell” rating.

“We’ve added an extra layer of mindfulness,” Gordon says. “When we review the portfolio, we’re now forced to ask the question, Is our itchiness just an emotional response? Or are there reasons to sell relative to risk and fundamental valuation?”