MEBISODE: When to Sell?

Key Concepts

• When to Sell: The central theme of the episode, focusing on the challenging decision of divesting investments.
• Investment Horizon: The importance of a long-term perspective when evaluating investment performance.
• Deferred Gratification: The ability to delay immediate rewards for future benefits, crucial for successful investing.
• Alpha: Outperformance generated by an active investment strategy compared to its benchmark.
• Drawdown: A peak-to-trough decline during a specific period for an investment, fund, or market.
• Style Drift: When a fund manager deviates from the stated investment strategy of the fund.
• Expense Ratio: The annual fee charged by a mutual fund or ETF to cover its operating expenses.
• Tax Efficiency: Strategies and investment vehicles that minimize the impact of taxes on investment returns.
• Havsies Approach: A methodology of selling or buying half of a position to mitigate risk and regret.

The Challenge of When to Sell Investments

The episode addresses a persistent challenge for investors: knowing when to let go of an investment. While significant effort is often dedicated to the purchase decision, many investors then "wing it" when it comes to selling, often driven by short-term performance. This approach is contrasted with a more structured and disciplined methodology for managing investments post-acquisition. The goal is to provide an "owner's manual" for investments, not just for specific funds, but for any investment held.

Three Categories for Evaluating Investments

The discussion is broken down into three key areas:

1. How Long to Give an Investment: The importance of establishing a sufficient time horizon for an investment to perform.
2. Dumb Reasons to Sell: Identifying common, often detrimental, motivations for selling.
3. Good Reasons to Sell: Outlining valid criteria for divesting an investment.

1. How Long to Give an Investment

A core argument is that investors often have a "woefully short time horizon" when evaluating investment results. The ideal approach is to adopt a "Rip Van Winkle" mentality, suggesting that doing nothing and allowing the portfolio to mature over time is often wiser than attempting to predict the future. This contrasts with the common desire for immediate returns and certainty.

• Charlie Munger's Insight: "It's waiting that helps you as an investor." Many struggle with this deferred gratification.
• Investor Surveys: When asked on Twitter how long they would give an underperforming investment, most investors cited "a few years at best."
• Professor Ken French's Perspective: When asked how long it takes to confidently know if an active investor is generating alpha, he stated, "Wait for it, 64 years." While this is likely too long for practical application, it highlights the inadequacy of short-term evaluations. French emphasizes that drawing inferences from 3, 5, or even 10 years on an asset class or actively managed fund is "crazy."
• The Need to Zoom Out: In an era of "investment confetti and TikTok investors," expanding the investment horizon is crucial. Holding investments for shorter periods increases the influence of randomness and luck on returns.
• Recommended Practice: Investors are encouraged to create a written plan stating a minimum holding period, such as "a minimum of 10 years." This provides a reference point during market downturns, preventing impulsive decisions based on short-term pain or regret. For example, if a new fund has a terrible first year, the plan can serve as a reminder that one year is "a lot of noise."

2. Dumb Reasons to Sell

A significant portion of the episode is dedicated to debunking common, yet flawed, reasons for selling investments.

• Focusing Purely on Recent Returns: This is identified as a "cardinal sin." Evaluating performance over a short window makes it difficult to distinguish long-term winners from losers. Even winning investments experience periods of underperformance.
  • Vanguard Study ("Keys to Improving the Odds of Active Management Success"): Examined 552 active funds that beat the market from 2000-2014.
    • 94% of these funds underperformed in at least 5 years (about a third of the time).
    • About half underperformed in at least 7 years (about half the time).
  • Warren Buffett's Performance: Even Warren Buffett has underperformed the S&P 500 in about a third of all years, including multiple consecutive years.
• Amazon as a Case Study: The transformative success of Amazon is used to illustrate how even great investments can experience severe drawdowns.
  • Amazon suffered multiple 50% drawdowns, including one exceeding 90% (the "Amazon.com bomb").
  • The question is posed: would an investor have had the foresight and discipline to hold through such "blood baths"? This highlights that even successful investments can appear as losers for extended periods.
• Emotional Attachment to Winners: Investors often become emotionally attached to well-performing investments and extrapolate that success indefinitely. This is a "very bad idea."
  • John Bogle's Research: Bogle tracked top-performing funds by decade and observed that these "high-fliers" consistently crashed back to earth and became underperformers in the following decade.
  • Bogle's Counsel: "Don't just do something, stand there." This emphasizes the importance of resisting the urge to chase past performance.
• Professional Managers Chasing Performance: The episode notes that even professional money managers are not immune to these behavioral biases.
  • Goyle and Wayhal Paper: Examined 8,775 hiring and firing decisions by 3,417 plan sponsors.
  • Finding: Professional managers chase performance and would have been better off staying with their previous managers in many cases.

3. Good Reasons to Sell

The episode outlines several justifiable criteria for evaluating and selling an investment. These should be established before the decision point arises.

• Asset Size Becoming a Hindrance: The assets of a fund strategy become too large to implement effectively.
  • Example: A fund that won "fund of the year" began buying up 20% of the float of stocks, leading to significant underperformance (multiples of 10-20 percentage points). "Size is the enemy of performance."
• Changes in Personal Goals: A shift in an investor's life circumstances, such as a new grandchild or unexpected health concerns.
• The Original Investment Thesis No Longer Holds: The fundamental reason for investing in the first place has become invalid.
• Fund Manager Retirement or Strategy Changes:
  • Retirement of a discretionary manager.
  • Style Drift: The fund's strategy deviates significantly from its stated objective (e.g., an S&P fund turning into a Bitcoin fund).
• Legal or Structural Tax Changes: New regulations or tax laws that make the investment strategy less effective.
  • Shareholder Yield Book Example: The dividend world's current disregard for share issuance and stock buybacks is cited as an example of a potentially outdated approach.
• Superior Diversification Offered by a New Strategy: A new investment provides better diversification benefits to the overall portfolio (e.g., selling US stocks to buy foreign stocks, or adding real assets or trend following).
• Increased Expense Ratios or Fees: The fund's fees become too high, or cheaper, more tax-efficient alternatives become available.
  • Example: Moving from high-cost, tax-inefficient mutual funds to low-cost, tax-efficient ETFs.

The Importance of a Written Plan and Honesty

The episode strongly advocates for incorporating these valid selling criteria into a written investment plan. Richard Feynman's quote, "The first principle is you must not fool yourself and you're the easiest person to fool," is highlighted. The key question for investors is whether they are "chasing performance or implementing a valid sell decision." A practical exercise suggested is to write down the reasons for selling in the plan and explicitly exclude performance as a criterion.

Advice During Tough Times: The Havsies Approach

When faced with difficult decisions, especially during tough market times, the advice is to "be your own best friend."

• Bill Dumel's Quote: "Every trade makes you richer or wiser, never both." This acknowledges that mistakes are part of the learning process.
• The "Havsies" Algorithm: A sophisticated approach to mitigate risk and regret is to "go havsies," meaning sell or buy half of a position. This diversifies possible outcomes and reduces emotional burden.
  • Manifestations of Havsies:
    • If undecided between two funds, buy both with smaller position sizes.
    • If considering selling a position, sell smaller portions spread equally over 12 months.
    • If nervous about a high valuation for a potential purchase, start with a small lot and expand over time.
• Pre-Planning is Key: The rationale for these decisions should be written down beforehand, not after the fact.
• Avoiding Binary Decisions: Investors are encouraged to move away from viewing investment decisions as strictly black or white. "Dipping your toe in the water" is acceptable, as long as it doesn't deviate from the overall process.

Conclusion

Effectively navigating market fluctuations and the inevitable over- or underperformance of investments is challenging. However, with deliberate thought, foresight, and planning, investors can overcome these hurdles. A balanced portfolio, coupled with a clear understanding of when to sell based on valid criteria rather than short-term performance, can lead to reaching financial goals and achieving peace of mind. This episode aims to equip listeners with the considerations needed to impact their portfolio performance, wealth, and overall confidence in engaging with the markets.