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.