Investors Behave the Same When They Buy and Sell, Don’t They?
There is ostensibly no reason why an investor’s skill would differ between buying and selling a stock. Both activities involve, at least theoretically, a similar process. But a recently published paper, ‘Selling Fast and Buying Slow: Heuristics and Trading Performance of Institutional Investors’, suggests that behavioural biases in decision-making can plague even the most sophisticated of investors.
In the 1980’s the American economist Richard Thaler observed that people often demand much more to give up an object than they would be willing to pay to acquire it in the first place. He named this ‘the endowment effect’. Thinking similarly a few years later, academics Daniel Kahneman and Amos Tversky coined the term ‘loss aversion’ to describe when the disatification of giving up an object is greater that the satifisfcation of acquisition. So how do these phenomena play out for investors?
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Investors Behave the Same When They Buy and Sell, Don’t They?
There is ostensibly no reason why an investor’s skill would differ between buying and selling a stock. Both activities involve, at least theoretically, a similar process. But a recently published paper, ‘Selling Fast and Buying Slow: Heuristics and Trading Performance of Institutional Investors’, suggests that behavioural biases in decision-making can plague even the most sophisticated of investors.
In the 1980’s the American economist Richard Thaler observed that people often demand much more to give up an object than they would be willing to pay to acquire it in the first place. He named this ‘the endowment effect’. Thinking similarly a few years later, academics Daniel Kahneman and Amos Tversky coined the term ‘loss aversion’ to describe when the disatification of giving up an object is greater that the satifisfcation of acquisition. So how do these phenomena play out for investors?
How to Study the Differences
The researchers tracked 783 long-only equity portfolios averaging $573m in size over sixteen years between 2000-16. The selected funds were tax-exempt, held limited cash positions, and didn’t use leverage – that is, in order to raise money to purchase a new asset, an existing position had to be sold. To evaluate performance, the authors created ‘control’ portfolios, which traded randomly and assumed zero skill.
One Type of Sell Trade Does Particularly Well
Earnings announcement days are predictable, easily accessible, and offer a wealth of new information. The authors use them as an isolated case study because they draw portfolio managers’ attention to the given stock and their behaviour can be examined.
They find that, while buying decisions perform consistently both on announcement and non-announcement days, sell trades on announcement days actually outperform ordinary day sell trades. Selling performance on earnings dates was +86 bps at a one year horizon, comparable to the +105bps for the buying performance on earnings dates.
But Most Sell Trades Do Poorly
In contrast, buys outperform sells by more than +200bps at a one year horizon on all other dates. The relative performance differences are similar at other horizons as well (see table extracted from paper below). This indicates that investors do not lack the fundamental skill to sell well; rather, it confirms the hypothesis of the paper that overall PMs allocate less effort to selling overall. Put technically, due to a greater devotion of cognitive resources to buying and a greater reliance on heuristics when selling, the latter systematically underperform when compared to a random counterfactual control.
Do Portfolio Managers Trade ‘Extreme’ Performance More Actively?
The authors assess whether portfolio managers trade stocks with extreme recent returns more, given that they grab their attention. They find that for buying decisions, past performance tends not to be an influencing factor. However, the probability of a sale shoots up for stocks with more extreme returns. Both the worst and best performing stocks in the portfolio are sold at rates more than 50 % higher than assets that just under- or over-performed. This holds true across all holding lengths. Intuitively, portfolio managers may think that stocks with extreme gains may have exhausted their further upside potential and in turn could mean revert.
Portfolio Managers Have Attachment Issues
The study found that portfolio managemers’ attachment to stocks could help explain the poor selling decisions. Managers showed the least attachment to stocks that were recently acquired and poorly performing, with the probability of selling such stocks at 5.6% compared to the ‘control’ probability of 2.3%. The probability of buying stocks did not exhibit a significant relationship with prior performance.
How to Overcome This Bias?
Funds spend a disproportionally high amount of time and effort on buying decisions and neglect their selling strategies, leading to underperformance. This can be explained by portfolio managers always being on the hunt for the next winning stock and so evaluating and rewarding traders on their successful buys instead of successful sells. Funds should therefore reward successful sell trades also. The paper concludes by suggesting that portfolio managers should adopt decision aids and simple alternative selling strategies.
Figure 1: Post-trade Returns Relative to Counterfactual
Source: “Selling Fast and Buying Slow: Heuristics and Trading Performance of Institutional Investors“
Reviewed by Presiyana Karastoyanova, Research Analyst at Macro Hive. Presiyana has previously worked at Nomura & Goldman Sachs, and has attained an MSc in Finance from Imperial College Business School.
(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)