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Selling Winners And Holding Losers – Even The Smartest Investors Get It Wrong

The study of how human instinct impacts on investment decisions is hotly debated and sometimes controversial. But even Ben Graham, the father of value investing, was aware of the potential for investors to err. He famously warned that “the investor’s chief problem – and even his worst enemy – is likely to be himself.” One of the best known behavioural trap-doors is to hang onto losing investments for too long and sell winning positions too soon. It’s a phenomenon known as the Disposition Effect. For years, researchers have warned that investors can damage returns by cutting winners and riding losers. Often, this warning has been pitched in the direction of relatively unsophisticated retail investors. But new research suggests that the same behavioural flaw exists in some of the market’s smartest and best-informed traders – Short Sellers. It serves as a reminder that the risk of succumbing to selling the wrong positions is something every investor needs to be aware of. So here’s a review of how things can go wrong and why smart investors are susceptible too. Why we sell the wrong shares If you were looking at a map of behavioural finance, you’d arrive at the Disposition Effect directly from two other places: prospect theory and mental accounting. These are theories about how humans make choices between risky prospects and how they categorise them based on different outcomes. In the context of investing, these theories claim that investors treat the probability of a loss differently to that of a gain. With the Disposition Effect, what this means is that investors irrationally sell winners and hold losers even though it often makes no economic sense. Some of the best research into the consequences of all this was done by Terrance Odean, who waded through 10,000 accounts held at an American discount broker between 1987 and 1993. He found a clear tendency for investors to sell winning positions over losing positions. Moreover, there was no good reason for it – there was no evidence that these investors were deliberately rebalancing their portfolios. On average, after one year, the losing stock, that was held, fell by 1.0% against the market. While the winning stock, that was sold, actually gained 2.4% above the market. Momentum rides on the Disposition Effect Clearly, Odean’s findings show that the Disposition Effect can damage performance – but not everyone loses. Readers of Stockopedia will know that we view Momentum as a core driver of market returns – as do a number of academics and investment professionals. So it’s worth mentioning at this point that the Disposition Effect arguably has a role in driving momentum. Given that research shows that investors sell winning positions too soon, there’s a read-across to companies that issue good news to the market. Some evidence suggests that the share price rise that goes hand-in-hand with good or surprising news can be artificially held back. And it’s held back by investors succumbing to the Disposition Effect and selling out of those ‘good news’ stocks too early. It causes something called post-earnings announcement drift, where the market takes a protracted time to price in the full meaning of the good news. This is one of the ways that momentum has been shown to work – very successfully for those who catch the wave. Smart investors make the same mistakes! If all this sounds a bit like like academics have been nit-picking at the fallibilities of individual investors, think again. In the evolutionary tree of the stock market, Short Sellers (despite their opaque nature) are regarded as some of the smartest investors around. Geared up to bet on shares that will fall in price means that they have to operate with a high degree of confidence. Ultimately, that means deep pockets and very detailed, industry-leading research. But very recent analysis shows that these guys are equally susceptible to the Disposition Effect. Watch out, we’re straying into the realms of double negatives here… but the evidence shows that short sellers are more prone to realising a capital gain on a falling share then they are to cut a losing position (i.e. a share that has risen in price). This is interesting stuff, not least because it hasn’t been looked at in detail before. In particular it shows just how powerful this natural urge to cut a winner really is. Plus it casts a small shadow over just how effective short selling is at making markets more efficient by pricing stocks correctly. The implication is that short sellers unwind profitable positions before they really should, or could do. The research was done by Bastian von Beschwitz (an economist at the US Fed) and Massimo Massa (a professor at INSEAD business school). They studied shorting activity on all US stocks between mid-2004 and mid-2010. Given the assumption that short sellers are very smart, there was a suspicion that they held on to losing (poor performing) positions because they knew they’d eventually come good. But it turns out this wasn’t the case – there was an element of irrational behaviour. Those profitable losing stocks became more profitable even after the short sellers had cut and run. As the researchers concluded: “…short sellers are closing more positions exactly at the time when it would be profitable to keep the short position open and profit from the negative future return. Thus, their tendency to hold on to their losing positions and close their winning ones causes them to lose money, a clear sign that it is not a profit maximizing strategy.” Circling back to the momentum connection, this new research also suggested that the Disposition Effect behaviour leads both long traders and short sellers to add to momentum. What can investors learn from this? For individual investors, news that the market’s most ruthless traders are prone to the same behavioural bias is perhaps quite reassuring. Unfortunately, it appears that individuals are more susceptible. Comparing Terry Odean’s 1998 research with their own, von Beschwitz and Massa found that the average retail investor suffered from a Disposition Effect that is approximately 6 times as strong as that of the average short seller. Overall, the findings reinforce many years of research that shows that selling winners too soon and holding losers too long can be costly. Dealing with this, of course, is another matter.

Is The Acceleration Factor A Better Way To Measure Momentum?

Momentum has received a lot of attention in the asset-pricing literature over the past several decades, and for good reason. Trending behavior is a staple in markets. In contrast with other pricing “anomalies,” short-term return persistence – positive and negative – is a robust factor across asset classes. The fact that momentum is deployed far and wide in the money management industry and hasn’t been arbitraged away suggests that the persistence factor is persistent. The question is whether momentum as traditionally defined can be enhanced? Yes, according to a small but growing corner of research that looks at price trends through an “acceleration” lens. Momentum is generally defined as the directional bias for asset returns to persist, particularly over a 6- to 12-month period. The modern age of momentum research begins with Jegadeesh and Titman’s 1993 study “Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency.” Fast forward to the present and you’ll find a small library of research that extends the analysis in a variety of directions, including the recent focus on the so-called acceleration factor. There are several ways to define acceleration, but the general concept is simply a methodology for measuring changes in momentum – “the first difference of successive returns,” as a recent paper explained ( “The Acceleration Effect and Gamma Factor in Asset Pricing” ). What’s the value of monitoring and measuring acceleration? This study finds that it provides “better performance and higher explanatory power than momentum.” As such, “momentum can be considered an imperfect proxy for acceleration.” That’s an intriguing comment since momentum is already viewed as a solid framework as a risk factor and as the raw material for profitable trading strategies. But can we squeeze even more from this realm of asset-pricing analytics in the search for robust signals? Perhaps. Another line of research along these lines comes to us by way of Morningstar, which recently published an academic study that found that acceleration is quite useful for anticipating severe market losses. ” The Economic Value of Forecasting Left-Tail Risk ” reports that the geometric return for the most recent six-month period less its equivalent over the preceding six months, along with trailing 1-year return, are powerful factors for predicting negative skewness in returns. The results suggest, according to the authors, “that it is possible to reduce tail risk without giving up returns.” There are a number of variations one could devise in trying to mine acceleration as a risk metric. David Varadi has explored several possibilities, including what he labels the volatility of acceleration (VOA). Noting that this indicator has interesting properties for estimating volatility and adjusting asset weights, he writes that “the VOA framework is one step in the direction of looking at alternative and possibly better measures of volatility.” The research on acceleration and its applications is still in its infancy, but the early efforts certainly look intriguing. It’s premature to abandon momentum in favor of acceleration. But there’s a compelling case for expanding the definition of price persistence.

The Recent Insider Selling Tells You Zip. Insider Buying Says Much More

In the ongoing debate about whether stocks are cheap or too expensive, the bears got some assurance from news that insider selling is on the rise. Investors often watch what insiders do because insiders are supposed to be better informed about their companies than the rest of us. So if insiders are selling, it must be because they know stocks are overvalued. Right? Not necessarily. I’m in the camp that believes stocks in general are too expensive right now. I would not be surprised to see another round of insider selling in the near future. Yet insider selling activity has no bearing on my view. On the contrary, I believe insider selling tells us very little about overvaluation. That’s because there are so many reasons why insiders might sell stock. A conviction that the stock is overvalued is only one possibility. Insiders might sell stock simply to raise cash. After all, insiders sometimes receive a relatively large proportion of their total compensation in the form of stock or options. Actual cash might make up a smaller proportion. So if these insiders want to buy a new home or send their kids to college, they might sell stock to raise cash. Insiders might also sell stock to diversify. It’s simply too risky for anyone to have all of their labor and most of their wealth tied up in just one company. It makes perfect sense for insiders to sell stock every once in a while to spread their wealth into other assets. Here’s yet one more reason why insiders might sell. Many employees are compensated at least in part with stock options. As a result, they can get hit with a tax liability when they exercise their options. They might sell some of the stock they received from exercising the options just to pay Uncle Sam. That’s not to say that a sudden spike in the amount of insider selling couldn’t be something to worry about. However, knowing that there are so many reasons why insiders might sell, I have to conclude that insider selling activity is not a useful signal of a market top. Insider buying is another story entirely. There are many reasons why insiders might sell, but there is only one major reason why insiders would buy. They buy because they believe the stock is undervalued. It’s true that a new member of the board of directors might be encouraged to buy some stock just for appearance’s sake, but that’s an exception to the rule. If insiders are using their own cash to buy stock, that a bullish signal. This just happened at one of the companies on my Bottom Line’s Money Masters recommended stock list. This company recently announced quarterly earnings that fell short of expectations. As often happens in such cases, the stock sold off in response. Yet my analysis convinced me that this stock is extremely undervalued. Apparently, several insiders agree. At least five of them purchased shares following the selloff. The CEO bought the most, spending $185,000 of his own money. That might not seem like a lot, but he didn’t acquire the stock as a result of an employee ownership plan or the exercise of options. He made a direct purchase on the open market using real cash. This CEO already owned a large stake in the company. The fact that he is willing to add to that stake should send a clear signal to other shareholders that the guy running the company is convinced the stock is cheap – so convinced that he is putting his money where his mouth is.