The dumbest mistake professional investors make

Netflix recently suggested I try Marie Kondo’s new show about tidying up. It’s called Tidying Up with Marie Kondo.

How Netflix knows I like tidying up, I do not know. But anyway.

Tidying Up with Marie Kondo purports to be about tidying up, but it’s really about throwing stuff out. It should be called Throwing Stuff Out with Marie Kondo.

Marie Kondo has a whole system to show you how to throw stuff out, but the basic gist is that we all have too much stuff and it psychically weighs us down and we should get rid of most of it.

Looking around my house, I had to agree with Marie Kondo. I do have too much stuff. Most people do. Why?

People have too much stuff because acquiring stuff is fun. It gives us a little momentary thrill. Even if the object of our affection is destined to spend the next seven years on a shelf in the spare room.

Throwing stuff out is harder. Or at least, it’s more boring. No thrills there.

Marie Kondo is here to say: there are two sides of this equation. If you insist on buying stuff, you need to get rid of stuff too. Editing your possessions is as important as adding to them.

And reading a draft paper on the Social Science Research Network on Thursday, I was reminded of Marie Kondo’s Netflix show.

The paper is called Selling Fast and Buying Slow: Heuristics and Trading Performance of Institutional Investors.

It’s about selling assets. The paper says professional investors pay way more attention to buying than to selling. As a result, their decisions over when to sell are much dumber than their decisions over when to buy.

It’s a crazy idea, really. What the paper is saying is that institutional investors dedicate their lives to finding great assets. They scrutinise them backwards and forwards, and value them accurately.

But having bought the assets, they basically leave them on a shelf in the spare room. They don’t value them accurately. And they sell them in the worst possible way.

And when I say the worst possible way, I don’t mean they sell them at random. Selling stocks at random would perform much better than the actual selling strategy employed by the professional fund managers in this study.

“In contrast, selling decisions not only fail to beat a no-skill strategy of selling another randomly chosen asset from the portfolio, they consistently underperform it by substantial amounts. PMs forgo between 50 and 100 basis points over a 1 year horizon relative to this random selling strategy, depending on the specification.”

Worse than valuing the assets properly and selling the overvalued ones; worse than selling assets at random; what they do is sell the asset when they either go up a lot, or down a lot.

“PMs in our sample have substantially greater propensities to sell positions with extreme returns: both the worst and best performing assets in the portfolio are sold at rates more than 50% percent higher than assets that just under or over performed.”

Why is that? The authors speculate portfolio managers need capital so they can do the fun part of the job: buying more stocks. In order to raise capital they sell whichever assets stand out — the ones that have either gone up or gone down a lot. “Assets with extreme returns are more than 50% more likely to be sold than those that just under- or over-performed.”

This isn’t how it’s meant to be. Ordinary investors are meant to be the ones that make silly mistakes. The pros are meant to have their head screwed on. But this research finds that many pros could improve their performance by around 1% per year, just by selling stocks at random. Let alone by actually valuing them properly.

Call it the Marie Kondo effect. People love the thrill of the new relationship, the new possession, the new investment. But the thrill quickly fades, and it’s onto the next new thing.

In the case of spare bedrooms it means cluttered shelves. In the case of portfolios it means dumb, poorly informed selling decisions. And worse returns.

As a professional portfolio manager myself, I got a kick out of this paper. I completely recognise it.

Not because I don’t pay attention to my selling decisions, or my existing portfolio. I recognise it because I have to force myself to pay full attention to my selling decisions and my existing portfolio.

It’s slow work. Not as exciting as finding an undervalued gem, or a company that’s brilliantly positioned itself for growth.

I liked this paper because it’s a morale booster, and a confirmation that I’m on the right track.

Before I buy a stock, I make a simple model of where its earnings are headed over the next two years. If its earnings growth and valuation line up, I buy the stock. Then, it’s just a case up updating the model every couple of months. If the valuation or earnings prospects get out of whack, it’s time to sell.

When it’s time to sell, I fire out an email update to my subscribers.

My newsletter? It’s called Technology Profits Confidential.
You can click here to learn more about it.
https://pro.agora.co.uk/m/1149204

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