Sunday, July 28, 2013

An essay on The Psychology of Selling in the Stock Market

Anyone who has been in the Stock Market for the past 10-20 years can tell you how volatile the markets are. They have seen and rode many bull runs where it can go straight up or bear runs where the market can go straight down in a matter of days. In between they also experienced the roller coaster stock market where the markets move up and down daily. Stock markets have grown much more volatile nowadays as compared to say 10 years ago because due to structural changes in the market. Due to the explosion of the internet, stock market information such as company announcement on earnings, corporate activity and other disclosures are transmitted almost instantaneous.

What used to take days can now be accomplished in seconds. Moreover due to the changes in our lifestyles everything needs to be done ‘here and now’. We have faster mode of transportation, communications, turnover in business and even our food are prepared much quicker like those in the fast food chains. As a result trading in the stock market has also quickened. With the arrival of online trading orders used to take minutes to complete can now be done in seconds.

Case for Buy and Hold

However many investors are still belonging to the old school where ‘buy and hold’ is the investing mantra for success. What you do is basically scan and select stocks that satisfy certain fundamental criteria such as good and continuous dividend yield, earnings, promising market and industry outlook and so on. Then you jump in and grab a few lots and hang on to it for whatever time period you reckon is reasonable or until your profit target has been reached. This buy and hold or rather known as strategic asset allocation revolves around a strategy whereby an investor who hold his portfolio long enough it will be able to generate returns equivalent to its average past returns. According to the theory, by holding long term it will help the investor overcome the short term risk associated with the market downturn.

Unfortunately the wait may be too long and the return may not be realized. The problem is many a time we don’t manage to sell and we end up where we began. To illustrate we present you the following chart for the Jakarta Composite Index as from Nov 2012 to July 2013.




As from the above say if you have bought stocks during the low of last year which is during the period of October to December and did not sell during the run up from January till the end of May this year. Then you would have missed a profit potential of more than 1000 points (5243 – 4222). In other words you are back to square one. I am sure you will regret for not selling in between those period. Unfortunately this has been the mistake committed by many investors during their trading career.

One thing to remember in stock market trading is that selling well is as important as buying well. To complete a transaction you need a buy and a sell if not you will be forever holding to paper profits as illustrated above.   Surprisingly this topic is not covered much in investment books and trading courses. In short, there are not much literature written about this topic probably it is a bit too taboo. All we are taught is how to protect our profits by moving our sell target or protective stops higher and cutting losses. There is not much mentioned on the psychology of selling and the reasons why selling is so difficult.   

Why Selling is so difficult?

There are many reasons preventing investors from making a sale and below are some of them. Some of them are due to internal which has to do with the investor’s psychology and external such as the broker or the brokerage firm.

First, it was the bonded feeling that was created when we hold our stocks for too long. When we keep something for a period of time we tend to get close and emotional to it. As an example if you have kept a pet say a cat or a dog for a period of time, there will exist a mutual feeling or understanding between them and us. Similarly in stock market investing there are certain nostalgic feelings that prevented us from liquidating our stocks even though it has past its prime. Reasons may be,
  1. the stock had treated us well by generating hefty profit earlier on
  2. someone is working in the company
  3. inherited from your parents
  4. still a darling among our investment circle of friends
  5. there is always hope for a comeback

Second, is the inability of us to admit that we are wrong. Selling means there is a complete reversal of our strategy. When we bought earlier we are in the consensus that it is going to go up due after our exhaustive analysis.  It is only a natural response psychologically that we feel nice and achieved a sense of fulfillment when we sell at a profit while we feel painful when we sell at a loss. This is because we tend to find ways to maximize our comfort while at the same time reduce our suffering.

Hence, selling other than for a profit meant we made a wrong decision earlier. Nobody likes to admit that they are wrong and hence we tend to shun selling. Buying always comes with the hope for gain and the possibilities of greater thing to come. Selling means there is an end to this story or an end of the game and thus diminish any hope for the possibility of the stock to stage a comeback.  Hence there is always a resistance to sell.

Third, holding on to loser always presents us with hope. When our portfolio is making money it gives us pleasure thinking that we are smart and we made the right decision by buying low and selling high. We are at the top of the world thinking of how we managed to beat the professionals, we are getting rich and we found our money fountain. We are at our emotional high and thinking of when are we going to change our old car, move to a bigger house, taking an exotic holiday but unfortunately such day dreaming never lasts. When the market turned, our stocks will go down and also our portfolio. The next thing you know is that you are now hoping that the market will not go down any further and you tend to hang on to whatever paper gains you still have. In actuality, this is the time to sell so that we can gather whatever capital we have to wait for the next buy opportunity. This will help make our opportunity cost option open.

However most investors tend to hold on to their losses because they not only made us poorer but also affects us psychologically like being stupid or foolish. Hence the best solution is to hang on because it is less painful.
 
Fourth, this may be due to the conflict of interest between the brokerage firm and their clients. To them the corporates are more important than their retail customers. This is because the investment banking side of the brokerage firms is doing a lot of business with them such as advising them on rights issue, mergers and takeovers, debt restructuring and so on. The revenues they generate from these activities are much more as compared to the commissions from retail market. The brokerage firm’s research analysts are also biased in their recommendation to buy or sell a particular company’s stocks. Sell recommendation are rarely issued because if they do then it will sour the relationship between the brokerage firm, investment bank and their customers. Future business dealings between them will be highly unlikely.

Another problem with the security industries is that in order to toe in to their marketing effort they tend to concentrate their effort on buying while the other side of the equation which is selling is completely ignored. Even when the topic on cut loss using the stop loss strategy was discussed the how and when part of the equation was seldom follow up in detail.

Another strategy used by brokerage firms to downplay a stock market fallout is to tone down the urgency to act. So instead of issuing a sell order they turn to other words that are more subtle such as,

  1. hold
  2. underperform
  3. long term buy
  4. perform in line
  5. market weight
  6. underweight

Thus, customers can almost never hope to receive sell recommendations from their brokerages.

Fifth, there are other less important reasons preventing us from selling such as phobia of overcoming commission, tax purposes, protect your ego and perfectionism.

Conclusion

In short, in order to become a more successful investor you must first learn to become a better seller. You must find ways to overcome you greed and fear that affects you psychologically. Success in investing is not easy because selling is more challenging than buying. You must find ways to overcome your resistance to selling. One tip from me is that whenever I wanted to sell I always asked myself. ‘If I am selling it now, would I be buying it again today’? 

Till now and Happy Trading !




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