Unfortunate truths about stock dilemma

Staying Ahead

November 24, 1997|By Jane Bryant Quinn | Jane Bryant Quinn,Washington Post Writers Group

HERE'S A PROBLEM an investor posed at a recent forum I attended: "I own a stock that has doubled in price. Should I sell it or hang on?"

Lots of people have "problems" like that, thanks to the long bull run. If they sell the stock and it goes further up, they'll kick themselves. If they hold and it falls, they'll kick themselves harder. What to do?

In truth, stock investors often make a hash of their sell decisions. I can tell you the implication of the latest research on the subject, but with this warning: It's ugly. Parental guidance may be needed before reading any further.

Unfortunate Truth No. 1: Investors tend to sell their winners rather than let their profits run. After they sell, they find another stock to buy. Leading to

Unfortunate Truth No. 2: Investors tend to replace their winners with stocks that don't do as well. Some stocks go down, leading to Unfortunate Truth No. 3: Investors don't sell their lousy stocks. They hold until the price "comes back" or at least starts moving up again. Then they often sell, without waiting to see if the stock might actually make a run. This plays into

Unfortunate Truth No. 4: If you need money, you'll probably sell a winning stock rather than a loser. That cuts off further profits in the winner and deprives you of the tax deduction that selling the losing stock would bring.

There are always exceptions, of course. Still, there are warnings one can draw from two studies by Terrance Odean, assistant professor of finance at the University of California at Davis. Odean followed 10,000 trading accounts at a large discount brokerage firm, from January 1987 through December 1993.

On average, he found that the stocks people sold did better than the ones they replaced them with. The new stocks under-performed both the old stocks and the market as a whole, measured over short- and long-term holding periods (four months, one year and two years).

Part of the reason was trading costs. Individual investors paid an average of 5.9 percent to sell one stock and buy another, including sales commissions plus markups in the price of the stock. Put another way, their new stock had to gain 5.9 percent just to bring them back to the starting line.

Another part of the reason may be their market timing. They often chose a stock whose price had been steaming up -- and may have the bad luck to buy toward the end of its rise.

Following this scenario through, let's say you hold the stock for a while and it disappoints. If you suddenly get another rise, you may decide to get out -- just before the price takes off again. This is hypothesis, not data, but fits with the experience of a lot of investors.

Most investors don't realize they've been making subpar choices, Odean says, because in this market, most stocks have been going up. You don't compare the stocks you buy with the ones you sold, and may not even compare your performance with that of the market as a whole.

Result: You may be far more confident about your investment abilities than your record warrants. Odean himself says he used to trade more speculatively, "but now that I've learned more, I trade less."

Over a two-year holding period, Odean found, stock trading cost the investors an average of 9.5 percent, in trading costs and lost stock performance. So buying and selling is probably hurting rather than helping your returns.

Odean's advice: Most long-term investors should buy and hold low-cost mutual funds whose managers also buy and hold rather than trade a lot. If you like individual stocks, pick companies you believe you can hold for years. And don't read the newspaper every day.

Retail stockbrokers, reading Odean's results, say, "Ha, that's what happens to investors who make decisions without a wise broker's guiding hand."

But who knows whether stockbrokers' customers would do any better? So far, no retail firm has offered to let Odean study its accounts. One is considering it but wants the right to decide whether the results can be published.

Do I detect a lack of confidence there?

Pub Date: 11/24/97

Baltimore Sun Articles
Please note the green-lined linked article text has been applied commercially without any involvement from our newsroom editors, reporters or any other editorial staff.