Fusion
That’s a question that has dogged professional investors for years.
Picking investments or trades to buy is one thing but when it comes to selling and in particular timing a sale its a whole different ball game.
In retail trading circles, this can cause us to snatch at profits and to run losing positions beyond the point where our money management rules tell us we should have closed the trade, with predictable results. It's a clear form of loss aversion (a cognitive bias that we should all be aware of) that stops us from making the rational call to close the trade.
Success in trading comes from running profits and cutting losses to grow our capital base and the ability to do this repeatedly, over as long a period as we can manage.
Having trouble selling isn’t confined to private investors, however. It’s a real issue among professional traders and money managers, unlike the science of buying or investing, which has been scrutinised to death by academics, analysts, traders and other financial markets participants. The science (or should that be the art of selling or divesting) has had precious little coverage in comparison.
The widely respected Barons magazine recently highlighted the asymmetry in professional money managers' selling ability and why professional can vastly underperform the market benchmark.
A research paper written by a mixture of US academics and specialists who measure investment performance or “skill “ as they like to call it, looked at 4 million trades made by money managers between 2000 and 2016 across 800 portfolios that on average contained more than USD 570 million of assets (aka "smart money").
The researchers found clear evidence of skill when entering trades or positions on the money managers' part, but it was a completely different story when it came to exiting trades.
In fact, the research found that the money managers were frankly shockingly poor when it came to timing sales, selecting what to sell and when to sell it. The researchers estimated that this lack of selling ability cost the managers returns of 2% per annum. Whilst that might not sound like much in insolation, if we consider the effects of compounding over decades that underperformance becomes hugely significant.]
That point is further reinforced by research by asset managers at JP Morgan Chase in 2014.
The fund managers looked at the lifecycle of 3000 US stocks dating back to 1980 what they found was striking as the quotes below show.
Risk of permanent impairment
“Using a universe of Russell 3000 companies since 1980, roughly 40% of all stocks have suffered a permanent 70%+ decline from their peak value.”
Negative lifetime returns vs the broad market.
“The return on the median stock since its inception vs an investment in the Russell 3000 Index was -54%. Two-thirds of all stocks underperformed the Russell 3000 Index, and for 40% of all stocks, their absolute returns were negative.”
Trades have a finite life cycle, and for the vast majority of stocks (or choose your asset class), they will often have their moment in the sun, get too close to it, and then fall away, never to return to those levels again. Identifying trades at their peak or going past their “sell-by dates" couldn’t be more important to an investment portfolio's performance.
In light of this knowledge, what can we do?
As with all the biases and psychological blackspots in trading that we discuss in our articles knowing and acknowledging that they exist half of the battle because we can modify behaviour accordingly once we have done that.
As traders in cash-settled margin products, we have an advantage over the money managers and asset owners described above. Simply because we are used to going both directions, e.g. shorting, on asset classes such as currencies and metals.
We take a 360 degree or holistic approach to the markets and the skills we use to decide to short USDJPY or the US 500 index can also be used to determine when a long position has run its course. Conversely, the skill set we use to identify a trading opportunity on the long side should also tell us when a short position is running out of steam.
Most traders we know of at Fusion do not hold their trades for more than a couple of days. Due to the power of leverage, they often don't need to since the gains can be enormous (but so can the losses we leave to run far longer than any positive P&L).
At the same time, why not make use of take profits or trailing stops to make sure you can squeeze that little bit extra out of the profit on the trade or set your levels and stick to them, without checking your phone or platform every minute of the day as we all do.
By adapting our mindset and the trading skills that we developed around opening trades, we can become better sellers or closers of positions and that will help us get the most out of the trades we make and the positions we take.