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Friday, February 6, 2009

Why selling is a common problem

Most investors tend to agree that the decision to sell a stock is one of the most difficult to make. Sometimes it is more difficult to decide when and what to sell than to buy. Ever wondered why?

* People tend to sell winners too soon and hold on to losers too long

You will find that regardless of whether the market is running hot or is coming down, there are still a lot of people out there who either sell their stocks too early only to realize that the prices continue to soar, or hold on to losers for too long only to see them continue to bleed further.

From a behavioural finance standpoint, this phenomenon is held by Hersh Shefrin and Meir Statman (1985) as the "disposition effect". This was discovered from their research entitled, "The disposition to sell winners too early and ride losers too long: theory and evidence".

Based on research, individual investors are more likely to sell stocks that have gone up in value, rather than those that have gone down. By not selling, they are hoping that the price of the losers will eventually go back to their purchase price or even higher, saving them from experiencing a painful loss.

In the end, most investors will end up selling good quality stocks the minute the prices move up and hold on to those poor fundamental stocks for the long term, while the performances of these stocks continue to deteriorate.

* People tend to forget their original objectives

In stock market investment, there are two types of investment activities, trading versus investing. Trading means "buy and sell" while investing means "buy and hold". The stock selection criteria for these two types of activities are entirely different.

Most of the time those involved in trading will choose stocks based on factors which will affect the price movement in short term, paying less attention to the companies' fundamentals whereas those involved in investment will go for good quality stocks which are more suitable for long-term holding.

However, you will find that many people get their objectives mixed up in the process. They get distracted by external factors so much so that some panic when the market goes in the direction that is not in line with their expectation, and as a result, end up selling the stocks that they find too expensive to buy back later.

On the other hand, some force themselves to change the status of the stocks that were originally meant for short-term trading into long-term investment as they are unable to face the harsh fact that they have to sell the stocks at a loss, even though they know that the stocks are not good fundamental stocks that can appreciate in value.

So, when to sell then?

There are few different schools of thoughts on this. Based on the advice from the investments gurus, like Benjamin Graham, Warren Buffet and Philip Fisher, when you buy a stock, you need to make sure that you understand the companies that you are buying, and these are good fundamental stocks, which will provide good income and appreciate in value in long term.

Therefore, you will be treating your stock purchase as a business you bought, which is meant for long term. You should not be affected by any temporary price movement due to overall market volatility.

You will only consider selling the company if the growth of the company's intrinsic value falls below "satisfactory" level or you find out that a mistake was made in the original analysis as you grow more familiar to the business or industry.

However, if you find that your investment portfolio is highly concentrated on one single company, then you might want to consider diversifying your portfolio and lowering your risk.

Any single investment that is more than 10 per cent to 15 per cent of your portfolio value should be reconsidered no matter how solid the company performance or prospect is, suggested Pat Dorsey of Morningstar.

Last but not least, if you find that by selling the stock, you can invest the money in a better option, then that is a good reason to sell.

In summary, successful investing is highly dependent on your self-discipline, taking away the emotional factors and not going with the crowd. It should always be backed by sound investment principles.

Always remember there is no short cut in investment, only hard work and patience.

Securities Industry Development Corp, the leading capital markets education, training and information resource provider in Asean, is the training and development arm of the Securities Commission. It was established in 1994 and incorporated in 2007.

SOURCE



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