Stock Selling Decision – Exiting The Chakravyuh (Maze) by Puneet Khurana
If ‘Abhimanyu’ of ‘Mahabharata’ would have been invited to speak at an investment conference, he will certainly have the most important advice for the investment fraternity
“Don’t enter the Chakravyuh, if you don’t know how to exit it”
“You might not have the exact plan to exit it, in-fact you can never have an exact plan, but you should have enough knowledge to make an informed exit decision based on the strategies and actions of the opposition army”
Replace ‘Chakravyuh’ with ‘Stock’ and ‘Opposition army’ with ‘Markets’ and you have a golden mantra for investors. One needs to have a good idea about when to exit a stock before making that crucial decision of buying. Not knowing when to sell has often led to high losses/misses for investors and is as important (may be even more) than knowing when or what to buy.
So when should we sell? What are the golden rules?
Tyler Durden of ‘Fight club’ would have put it like this: “The First Rule of selling is that is no rule”
Don’t get me wrong here. What I am saying is that there is no generic ‘suit-all’ rule. One makes his own rule to selling as per his comfort and strategy. But there are some underlying principles for the same.
- Reason of entry
- Better Opportunity
- Psychological Strength of investor
- Tax Implications
Let’s look them one by one
Stock Selling Decision – Reason For Entry
The selling decision should always be governed by the reason for which you entered the stock at the first place.
The question, ‘When to sell’, is often misinterpreted by most investors as, ‘What price to sell it for’. But these are two very different questions. The only set of market participants for whom these are same questions are ‘Technical Analysts’. The reason is simple. Since their reason for entry was predominantly based on price, their exit strategy and their risk management is also based on the same. That is why you hear the term like ‘Stop Loss’.
For value investors, the reason to enter is not ‘Price’ but ‘Value’. Value investors tend to buy when the price of a company stock is far less than the estimated intrinsic value of it.
So the logical interpretation of this statement is that the reason to sell for Value investors should be ‘Value’.
- Either the price of the scrip which was earlier at a huge discount to the range of intrinsic value calculated has now moved up to approach the estimate value number
- Or the calculated intrinsic value estimate has reduced because of some new evidence coming to surface and hence the perceived discount is no more there. Your thesis on which you made your calculation gets challenged.
- Or the calculation of Intrinsic Value was estimated on faulty assumption and the mistake is realized. Your thesis was wrong.
So the basis of decision is the ‘Value’ of the stock and the difference between ‘Price’ and ‘Value’. For same reason, value investors who do their work properly are happier to add when the price falls as the discount of what they wanted to purchase have increased further
Another reason for which on should exit is an availability of better option. Every new idea that one works upon should be compared to the existing positions in the portfolio. Ultimately, a new entry is a capital allocation decision and capital is going from either a stock (or Cash) to the new opportunity and hence the decision should be acted upon only when the new opportunity presents better return possibility (risk adjusted).
Psychological Strength of Investor
Next major factor which governs selling decision is the psychology of the investor. Since, the returns in stock markets are never linear; the inherent volatility makes it difficult to hold on to winners for long time which, if you ask me, is what differentiates a good investor from a great one. Every investor I have interacted with has a different rule to tackle this issue. I call these actions as ‘Psychological hedges’.
Some people decide to sell half quantity at double price so effectively making the remaining position free of charge (FOC). There is no rational logic to that decision but we are humans. After all,
Man is not a rational animal, but a rationalizing one
Some people decide to sell some portion when the Price reaches within 10% of Intrinsic Value calculation while other wait for it to go to some premium level because they believe that when prices start moving up, it never stops at intrinsic valuation.
Some investors buy and sell their full positions in one go.
Whatever your method is, you must tailor it in a way that helps you fight the psychological biases and help you hold on to winners for long.
Lastly, I believe tax considerations are important when making a selling decision. If one’s thesis has changed or was proven wrong, tax consideration is the last thing one should be worried about. The best decision at that point is to ignore it. But for all other practical purpose, it should not be ignored. A position held for a shorter term should be sold for profit only when it compensates for the taxes that you would have otherwise avoided by holding it for the long term. That is also one reason, why people who buy and hold are able to outperform lot of short term traders because not only they save a lot on transaction costs, they save substantial amount of money by not paying taxes which short term traders have to.
Keeping in mind these 4 underlying principles can help investors devise the best strategy to exit their positions.
Puneet Khurana is a fund manager who headed research for billion dollar hedge funds and currently operates as an individual money manager. He is also a visiting faculty at one of the most prestigious college in India (IIT, Delhi) where he teaches Behavioral psychology and Finance. He writes and conducts podcasts at stoicinvesting.com and one can connect to him via twitter handle : @PuneetK009