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The Art of Selling
“It struck me that selling smart is probably the single most important element of investment success over the long haul." ~ Sanjoy Bhattacharya
The market downturn over the last six odd months has made me return to the drawing board on the art of selling.
Selling is one of the most difficult disciplines in investing. We have simple rules to sell. They are as follows:
- When we find a better company to switch to
- When the management does something negative that we did not anticipate
- If there is headwind in the industry
- If our stop loss is hit
- Change to the overall market regime - New addition to our process
In a very choppy market, investment stop losses are usually not hit and the stock keeps going up and down before the major fall comes in. We exit at the major fall. This, at times, is also very close to the short-term bottom. And the stock can then slowly recover after we have exited fully or partially.
When we go to cash, there are two main considerations:
- Protect the portfolio from catastrophic losses.
- Not to miss out on a large part of the recovery when it starts
When the market is falling, no one knows how far and for how long it will fall. So, at some point, when the protective stop losses are triggered, it could very well be near the bottom. But that can be only known in hindsight.
The objective is always to protect from large losses. Also, when the recovery starts, and we are in cash, the portfolio tends to underperform for a while because the cash component acts as a drag. This is a trade-off that we need to make. There is no optimum way of handling this problem. Some managers decide to sit through the entire drawdown. I prefer getting out and then getting back in when things are slightly clearer.
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Edges in Investing
The investing world is changing. And fast. The use of computers has already completely infiltrated the domain for many years. Gone are the days when annual reports were sent by post to investors, when concalls were only for institutional investors or not at all and when access to information was scarce. The biggest edge in earlier days was access to information. Investors have made billions just because they had better and faster information than others. A lot of this may be construed as insider trading were it to happen today.
The informational edge is eroding the fastest in today’s day and age when information flow has been largely democratised. It will get even more so with the advent of AI tools. Investors must rely on other edges to be successful.
There are some edges in the market that an investor can have. To be successful, an investor needs to actively inculcate many of these edges.
Informational Edge: This is when an investor has access to information before others or more than what others have. An investor can interact with industry insiders to gain legal insights, do scuttlebutt from vendors, ex-employees, competition, attend investor conferences and do primary research. Additionally, larger organisations can also access what is now known as alternative data (satellite imagery, foot traffic, web traffic, credit card consumption data, social media analytics etc). He can also have access to sophisticated tools for analysing corporate filings and sentiment analysis.
Analytical Edge: This is when an investor can better interpret public or private data. This can be achieved by having better mental models and frameworks, second and third-order thinking and variant perception. It is also present when the investor has deep domain knowledge and can analyse information differently than others not so well-versed.
Behavioural Edge: The ability to act rationally when others act emotionally. The ability to remain calm under extreme volatility and a patient, measured response to events is usually an outcome of either an individual psychological trait. A lot of behavioural edge can be obtained by following rule-based investing.
Decision Edge: The ability to make decisions with incomplete information. Investing is a field where there is never 100% certainty. A decision edge is the advantage gained by making higher-quality, faster, and more consistent decisions under uncertainty, especially when facing noisy, incomplete, or conflicting data. It reflects how an investor thinks, how he decides, and how he evolves his judgment over time.
Time Horizon Edge: This is a major edge as most investors are oriented to maximise their short-term gains in what is termed as “quarter se quarter tak” views. If an investor has a long term view and can delay gratification, he can remain calm during short term volatility.
Structural Edge: Sometimes, an investor can access markets that others can’t. For example, an individual investor has no performance or redemption pressures. They are not usually constrained by the liquidity of a stock. At times, an institutional investor can get deals that a retail investor cannot.
Process Edge: An investor can have a robust, repeatable, evidence-backed, and adaptable investment process. He can use rules, checklists, screens, and ranking frameworks for analysis. He can have written down or coded pre-committed entry, exit, and risk management rules to manage an investment position. He can also have clearly defined feedback loops for refining this process based on the outcomes of previous investments.
Network Edge: An investor can have access to better minds, mentors, or investor collectives. Most sophisticated investors are part of some close groups where they can brainstorm ideas. Although there is no alternative to personal connections, virtual networks in the form of investor forums do play a good part in this.
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- How does one arrive at a conclusion about change in market regime?
- How is major fall defined?
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Both are subjective questions. So, different investors would respond to it differently. If one is a short term investor (time horizon < 1yr) then it would be different from one with a long term horizon.
One of the easiest and most prevalent ways is to use multiple moving averages to determine the market regime. For example, lets take 20,50 & 200 day moving averages.
If the market (a specific index) is above the 20 dma, then it is in short term uptrend. If above both 20 & 50 dma, then medium term uptrend and if above all 3 dma’s then in long term uptrend.
One can work out various scenarios with these 3 (or any other combination of) moving averages.
The one I am starting to use is a bit more complicated than this and uses multiple indicators and a composite score.
Similarly, defining a significant fall is also subjective. But in general, one can look at a scenario where the index/stock falls below a significant moving average, like 200 dma.
The drawback of such a system is that, at times, one will be selling very close to the bottom. That is a risk that one carries in any stop-loss-based strategy, and the main reason why stop losses reduce overall returns over time, though they reduce volatility.
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With so much going around in the world, I sat down with Arjun Nagarajan, Chief Economist, Sundaram Mutual Fund, to make sense of it all.
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