selling a stock (ii): found a better one

A valid reason for selling a stock in your portfolio is that you’ve found a similar one with better risk-return characteristics.

Sounds straightforward:  you own one that you think can go up by 25% and, perhaps by studying the industry further, have found a competitor with a better product that you think can go up by 50%.  So you switch.  What could be simpler?

Strangely (to me, anyway), it’s not what people–even investment professionals–always do.

Consider this situation:

You find a stock trading at $100 a share that you think can go to $120, a 20% return.  You buy it.  Instead of going up, however, it drops to $90, even though the company’s prospects haven’t changed.  So the stock now has a return potential of 33.3%.

You find a close substitute, again trading at $100 a share.  But this second company has the potential to go to $150, a 50% gain.

What do you do?

Decide before you read further, please.

Believe it or not, virtually every securities analyst I’ve ever trained to be a portfolio manager says he’d wait for the first stock to rise to $100, then sell it and use the proceeds to buy the second.

Why is that the wrong answer?

Forget that you already own the first stock.  That’s irrelevant.  You can sell it in an instant at almost no cost.

You have a choice between a stock that can go up by 33.3% and one that can go up by 50%.  Both have similar risk profiles.  You should be holding the second, not the first.

Why do people want to continue to hold the first?  …it’s because their judgment is colored by the fact that they have a loss on it.  They’re more concerned about being right in their initial judgment than they are about making the highest profit.  So they don’t fully process the new information they develop.  The second stock isn’t going to wait at $100 for you to satisfy your ego.  Besides, in a taxable account, a recognized loss has at least some tax value.

2 responses

  1. This is exactly me. I put on an $AAPL position, made a slight loss over a 4 month period, and thought about how $FB was looking really cheap at $24. Now I’m so unhappy about the measly 5% pop on $AAPL’s Q3 earnings, which only brought me to breakeven, after watching $FB soar +26%….

    • Thanks for your comment. This happens to virtually everyone. The important thing is to remember to look at this kind of situation in a different way from now on. You might also try to think back to when you made the decision to stick with AAPL and remember how you felt about both stocks. If you had even a vague feeling of unease about AAPL you might want to keep it in mind in case the same bad feeling might recur with another one. If a pattern develops, it may be not-yet-fully-formed, but still useful,ideas trying to push themselves to the surface.

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