Continued from Part 1...

Remember, understanding the theoretical principles is just the first step- the most important part is trying to figure out how use it in action. Today I wanted to mention just one of the topics that deals with the question that I get e-mails about most often- how and why should one choose when to sell stocks?

In my opinion- selling strategy could actually be more important than the buying one. Remember, nominal stock prices go up in the long haul- pure and simple, and thus your diversified portfolio is very likely to go up regardless of when and what exactly you buy, if you just leave it alone for long enough period of time.

In my experience, however, the single biggest mistake investors make is selling out too early. Here is my advice and rule of thumb - NEVER sell stocks on the way up- sell them ONLY on the way down. Yes it might sound counterintuitive and make people question my logic, but that might be just the single biggest factor in why some people do better in investing than others.
Why does it work this way? Weren't we all taught that it is a better to set a target price and sell it when the stock reaches it? Before jumping to conclusions simply too quickly -consider these few findings of behavioral finance and try to apply them to the stock market:

1. "Loss aversion"-

humans have been found to strongly prefer avoiding losses to acquiring gains- it means that people, on average, refuse to admit that they made a mistake by buying a particular stock and thus end up sticking to losers when they should have been selling. Social Psychology Fourth Edition, Aronson et al., p. 175: "Once we have committed a lot of time or energy to a cause, it is nearly impossible to convince us that it is unworthy"

2. "Endowment Effect" -

"People place a higher value on a good that they own than on an identical good that they do not own" - by Kahneman, Knetsch, and Thaler (1990

3. "Disposition Effect"-

"Investors are unwilling to recognize losses (which they would be forced to do if they sold assets which had fallen in value), but are more willing to recognize gains". "Shefrin and Statman (1985) predicted "that because people dislike incurring losses much more than they enjoy making gains, and people are willing to gamble in the domain of losses, investors qill hold onto stocks that have lost value (relative to the reference point of thir purchase) and will be eager to sell stocks that have risen in value. They called this the disposition effect."Montier (2002) pages 23-24

4. "Post-purchase rationalization" -

"...common phenomenon after people have invested a lot of time, money, or effort in something to convince themselves that it must have been worth it. Many decisions are made emotionally, and so are often rationalized retrospectively in an attempt to justify the choice"

Now, these are just a few of the well researched human biases that affect investor's behavior when they make investment decisions - but all of them point us to the same conclusion- investors on average sell winners too early and hold on to their losers for too long... And if on average people make the same mistake over and over again- the smartest thing you could and should do- is take advantage of it and do just the opposite, hence my selling rules...

Anyway hopefully that helps to answer some of the questions, for now stay safe and please feel free to e-mail with any questions at skepticalcapitalist@gmail.com