Frederik Vanhaverbeke

Three Classic Mistakes in the Last Step of the Investment Process – Buying and Selling
In my book Excess Returns: A Comparative Study of the Methods of the World’s Greatest Investors, I explain how the world’s most successful investors set about beating the stock market and how they try to avoid the errors that other investors make.

 

Mistake 1: Trying to Sell at a Peak or buy at a Bottom

 

Many investors think – wrongly – that successful investors buy shares at their low point and sell them at their peak. The idea that one can time buys and sells with pinpoint precision is the product of a number of psychological biases.

First of all, many think that stock markets are easier to predict than they actually are. Second, human beings tend to discern certain patterns in how share prices move, whereas, in reality, most price movements are more or less random.

These convictions, coupled with excess confidence, lead to the idea that it has to be possible to apply some kind of method to time buys and sells perfectly.

In a predictable world, timing would indeed be a matter of logic; however, stock markets are anything but predictable. Even the world’s most successful investors think that perfect timing is impossible – who are we to think otherwise?

Top investors don’t look for the perfect way to time their purchases and sales, rather they are pragmatic in making buy and sell decisions.

They accept the fact that a stock may go down after the purchase, or that a stock may go up after a sale – their overriding concern is whether the share is expensive or cheap compared to its intrinsic value.

They realise that it makes no sense to keep an overvalued share, speculating that the price could go even higher, and believe that it’s silly not to buy a cheap share because the price might go down a little bit more.

To avoid having to time purchases, top investors tend to spread them over time and within a given price range.

Figure 1 illustrates how Prem Watsa – nicknamed ‘the Canadian Warren Buffett’ because he’s achieved investment returns similar to Buffett’s – bought and sold shares in International Coal between 2006 and 2011.

Watsa bought an initial small position in 2006 at $4.6, after which he seriously increased that position in 2007 at a somewhat lower price of $4.4. When the share slumped in 2008 in the middle of the credit crisis, he added to his position at a price of $1.8 and in 2009 he took advantage of the low share price, buying an additional package of shares at $2.9. As the diagram shows, the share recovered spectacularly in 2010 and 2011, allowing Watsa to sell the position off gradually with high profit at $7.3 in 2010 and $14.6 in 2011.

 

 

Classic Mistakes 2

 

 

Figure 1: Buys and sells of International Coal by Prem Watsa between 2006 and 2011.

 

‘Seasoned bargain hunters understand that it is their common plight to sell stocks too soon, particularly as they find cheaper bargains elsewhere. If you hold on to your stocks as they rise above their estimated worth, you are joining a game of speculation and have left the sphere of investing. John Templeton
Mistake 2: Selling a Strong Share with the aim of Buying it Back Later at a Lower Price

 

Closely related to the timing mistake is the attempt made by some, possibly over confident, investors to sell a strong share, with the aim of later picking it up after a price correction and thereby running a big risk of exiting the share for good.

In fact, these investors are trying to do something that is twice as difficult as selling at a peak and buying at a bottom:

 

  1. They have to sell the share close to a peak, but if they sell the share before it’s reached a peak, they often refuse to buy the share back above the sale price because this is viewed as locking in a ‘missed profit’.
  2. Even if the sale turns out well and the share corrects, they still need to buy the share back close to a floor; many investors think that the correction will be much greater than it actually is and so they wait too long to buy the share back. Once the share starts climbing again (and rises back above the sale price), they’re anything but keen to buy it back.

 

Mistake 3: No one has Gone Broke by Taking Profit

 

This conventional wisdom is as old as the stock market itself and follows seamlessly on from mistake 2.

Of course, it sounds logical: if a share has performed well, it makes sense to secure the profit so that it can no longer be lost. In addition, many investors are under the unconscious impression that strong performing shares have ‘used up’ their upward potential, so it’s plain to them that they should be replaced with shares that still have upward potential.

Top investors consider this stock market truth to be nonsense; the exceptional performance of their portfolios is often attributable to a limited number of shares that have performed particularly well and that they’ve been holding for years, if not decades.

Warren Buffett, left, who has achieved an average annual return of about 22% since 1957 (12% better per annum than the S&P 500) can mainly thank around 15 shares that he has held on to for many years for this exceptional performance.

Shelby Davis, who managed to turn $100,000 into $900 million over his 45 year investment career, could attribute that exceptional performance to a handful of shares that he kept for a number of decades.

It is furthermore remarkable that even many successful traders say that their outstanding performance is due to a limited number of shares that they’ve held on to for a long time.

There’s nothing all that wrong with taking profit on shares that have risen sharply; indeed, it makes sense to sell shares that have risen so spectacularly that they are (heavily) overvalued. However, systematically selling off just any strongly performing share for the sake of it makes no sense at all.

The share price of an exceptional company should perform outstandingly well on the stock market. But this doesn’t automatically imply that the share is overvalued. Serious investors take changes in the share’s intrinsic value into account and compare that with its price on the stock market. It’s only when a discrepancy arises between the two that a sale is advisable.

Thus, it’s a far better stock market truth, which top investors stand behind: ‘hold strongly performing shares as long as the company continues to perform well and as long as the share price does not get (too far) ahead of the results.’

 

In Part 3 I look at two more harmful buying and selling mistakes.





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