Howard Max's first new year's memo: Don't sell stocks just because the price goes up or down

"Buy low, sell high" is a basic cliché in investing, but it has always been so, right?

Oak Capital co-founder Howard Max, in his latest investment memorandum, seriously refuted this rule:

"It certainly doesn't make sense to sell just because the price has gone up."

Of course, instead of selling because of a price increase, it is worse to sell because of a falling price.

For decades, Howard Max used to writing annual memos about investments that are now regarded as classics by many in the investment community.

In this memo talking about "selling," Max argues that the reason for selling should be based on the investment prospects — fundamentals, financial analysis, stylistic guidelines, etc. — not on regret and fear of making mistakes.

In addition, Max expressed his views on timing and active management:

"Selling in order to get the timing of the market is usually not a good idea. There are few opportunities to profit from doing so, and few people have the skills needed to take advantage of them. ”

"In fact, in most cases, active investing impairs performance: most equity funds fail to keep up with the index, especially after deducting fees."

In Max's view, investing means putting money into an asset based on a reasonable estimate of its potential and benefiting from long-term outcomes, rather than "going in and out of a single asset and the entire market on the basis of guessing the price movements of the next hour, day, month or quarter".

The following is the full text of the memorandum:

———————————————————

I've been writing memos for 40 years now, and sometimes I think it's time to stop writing because I've written all the relevant topics. But now, a new idea has emerged.

I recorded a conversation with my son Andrew about investing in 2020 in my 2021 memo, "Some Things About Value," where we briefly discussed whether and when to sell assets that have appreciated in value.

It dawned on me that although selling was an inevitable part of the investment process, I had never written a full memo specifically for it.

The basic idea

Everyone is familiar with the old saying that it is the basic proposition of investment: low suck high throw. This is a cliché that most people look at investment, but the important things are rarely summarized in a few words. Therefore, "low suction and high throw" is just a starting point for a very complex process.

Will Rogers, an American film star and humor guru of the 1920s and 1930s, offers a guide to what he thinks may be a more comprehensive pursuit of wealth success:

"Don't gamble. Take all your savings, buy some good stocks, hold them until it rises, and sell them. If it doesn't go up, don't buy it. ”

Obviously, his advice is as simple as many other aphorisms, but illogical. Regardless of the details, people have accepted that "appreciating investments should be sold", so how much can the basic concept of "low suction and high selling" help?

origin

Much of what I've written here stems from a 2015 memo called Mobility. A hot topic in the investment community at the time was concern about the decline in liquidity provided by the market (when I refer to "market", I mean the US stock market, but this term is also widely applicable). This is often attributed to:

• the blows suffered by investment banks during the 2008-2009 global financial crisis;
• The Volcker Rule, which prohibits major financial institutions from engaging in high-risk activities such as proprietary trading, limits banks' ability to "short" or buy securities when customers wish to sell them.

Maybe 2015 was less liquid than before, maybe not. However, in that memo, I stated my point at the end:

• Most investors trade too much, which is not good for themselves;
• The best solution to illiquidity is to build a long-term portfolio that does not rely on liquidity for success.

Long-term investors have an advantage over short-term investors (I think the latter describes most of today's market participants). Patient investors are able to ignore short-term performance and opt for long-term holdings to avoid excessive transaction costs, while others are worried about what will happen next month or the next quarter and therefore over-trade. If illiquid assets can be bought at low prices, long-term investors can also benefit from them.

However, like many things in investing, holding stocks is easier said than done, and too many equate operations with increased value. Inspired by what Adrew said, I summarized this idea in Mobility:

When you find an investment with long-term compounding potential, one of the most difficult things to do is be patient and maintain your position based on expected returns and risks. Investors are easily struck by the news, emotions, the fact that so far they've made a lot of money, or the excitement of a new idea that looks more promising.

When you look at the charts, you'll see that some stocks have been rising for 20 years, then moving to the right, and think about how many times holders have had to convince themselves not to sell.

Everyone wanted them to buy Amazon for $5 on the first day of 1998, as it's now up 660-fold to $3304.

• But when the stock reached $85 in 1999, who would hold it? In less than two years, the stock has risen 17-fold.
• In 2001, when the stock price fell 93% to $6, who could avoid panic among those who persevered?
• Who wouldn't sell when the stock price reached $600 (100 times higher than the 2001 low) at the end of 2015? However, anyone selling for $600 only got the top 18% of the overall rise from that low.

It reminds me of a trip to Malibu with a friend, and I mentioned that the Ringge family is said to have bought the land in 1892 for $300,000 — a total of 13,330 acres, or $22.50 per acre. Today it is clearly worth billions of dollars.

My friend said:

"If only I were the one who bought Malibu for $300,000,"

My answer is simple:

"When it goes up to $600,000, you're going to sell it."

After writing Liquidity, I became more and more convinced that people sell investment products for two reasons:

• They went up;
• They fell.

You might say, it sounds crazy, but what's really crazy is the behavior of many investors.

Sell because it's up

"Profit-taking" is a clever-sounding term in our industry, referring to selling something that has appreciated in value.

To understand why people are involved, you need insight into human behavior, because many of investors' selling behavior is driven by psychology.

In short, a lot of sell-offs happen because people like to see their assets show gains and are afraid that profits will disappear. Most people spend a lot of time and effort avoiding unpleasant feelings, such as regret and embarrassment. What could be more reproachful to investors than watching huge gains evaporate?

If professional investors reported a bumper harvest to their clients in the last quarter, what should they do next quarter and have to explain why the stock price is below cost?

It is human nature to want to realize profits to avoid these results.

If you sell an asset that has already appreciated, you can "pocket the money". As a result, some people think that selling is very desirable – because they like the gains that have already been realized.

In fact, at a meeting of a nonprofit investment committee, one member suggested that they should be cautious about increasing donation spending on gains that have not yet materialized.

But I would like to point out that it is often wrong to treat realized gains as determined over unrealized gains (assuming there is no reason to doubt the authenticity of unrealized holding gains).

Yes, the former is already solidified, yet gains are often reinvested, which means that profits and principal are put at risk again.

One could argue that appreciating securities are more at risk of falling prices than new investments currently considered attractive, but this is far from certain.

I'm not saying that investors shouldn't sell appreciating assets to achieve gains. But it certainly doesn't make sense to sell just because they're priced.

Sell because it fell

While it is wrong to sell an appreciating asset just to make a profit, it is even worse to sell just because the price has fallen.

Still, I'm sure a lot of people will do that.

While the rule is "suck low, sell high," it's clear that the more many people fall, the more motivated they are to sell their assets.

Indeed, just as continued purchases of appreciating assets will eventually turn a bull market into a bubble, a massive sell-off of falling assets has the potential to turn a market downturn into a crash.

Bubbles and crashes do happen from time to time, proving that investors are fueling excess in both directions.

In my brain, this type of investor would buy something for $100.

If it goes up to $120, he'll say, "I think I've made some progress, and I should make some additional investments." ”

If it goes up to $150, he'll say, "Now I'm very confident, I'm going to double." ”

On the other hand, if it falls to $90, he will say, "I will consider increasing the position to reduce the average cost." ”

But if it falls to $75, he will reconfirm his investment criteria before further reducing the average cost.

At $50, he'll say, "I'd better wait until the dust settles before I buy." ”

And at $20, he'll say, "It feels like it's going to zero, let me go!" ”

Just like those who fear losing gains, many investors worry that their losses will double like compound interest.

They may worry that their clients (or themselves) are saying, "What kind of idiot would continue to hold an asset after it has fallen from $100 to $50?" ”

Everyone knows that such a fall could be a harbinger of a further decline, and then — look, it happened.

Do investors really make the behavioral mistakes I describe?

There is a lot of evidence to prove, for example, that the average performance of fund investors is worse than the average performance of funds.

How is this possible? If an investor's position remains unchanged, or if the mistake made is non-systematic, then the average performance of the fund investor should be the same as that of the fund.

Investors are outperforming, meaning they are reducing their holdings of funds that perform better later and overweight those that perform worse later.

Let me put it another way: on average, fund investors tend to sell the worst-performing funds recently (missing their recovery) in order to chase the best-performing funds (and therefore may participate in their pullbacks).

As mentioned above, we know that "retail investors" tend to be trends followers, so their long-term performance tends to be affected. What about pros?

At this point, the evidence is clearer: In recent decades, there has been a strong shift toward indexation and other forms of passive investing for the simple reason that proactive investment decisions are often wrong.

Of course, many forms of error contribute to this reality. Whatever the reason, however, we must conclude that, on average, active professional investors hold mostly underperforming stocks and fewer outperform the broader market, and they buy too much at high prices and sell too much at low prices.

Passive investing has been good, just not grown enough to cover most mutual funds in the U.S., but I think active management is too bad.

When I worked at First National City Bank 50 years ago, potential clients used to ask me, "What kind of return do you think your stock portfolio will bring?"

The standard answer is 12%. Why?

"Well," we said simply, "the stock market returns about 10 percent a year." With a little effort, we can improve by at least 20% on this basis. ”

Of course, as time goes by, "a little effort" doesn't add anything. In fact, in most cases, active investing impairs performance: most equity funds fail to keep up with the index, especially after deducting fees.

What about the final proof?

The key factor in OakTree Capital's investment in distressed debt — cheap acquisitions — stems from the huge opportunities offered to us by sellers.

During economic and market crises, negative sentiment can peak, causing many investors to feel frustrated or frightened and sell stocks in panic. Only when the holder sells to us at an irrational low price can we achieve the set investment objective.

Good investing is largely about taking advantage of the mistakes of others. Obviously, selling because of falling prices is a mistake and it presents a huge opportunity for buyers.

When should investors sell?

If the price increase is not the reason for selling, then the fall should not be.

Is selling the right thing to do?

I mentioned before that I had some valuable discussions with Andrew in 2020. That experience was truly valuable – it gave an unexpected glimmer of hope for the pandemic.

That memo provoked the strongest response from readers of any of my memos to date. This reaction may be attributed to:

• The content of the article - mainly related to value investment;
• The personal insights provided, especially as I acknowledge that I need to keep up with the times;
• Reproduced dialogues (partial) included as an appendix:

Howard (hereinafter referred to as H): I see XYZ up xx% this year and the price-to-earnings ratio is xx. Will you want to sell and make some profit?

Andrew (hereinafter referred to as A): Dad, I told you I am not a seller, why should I sell?

H: Well, if you choose to sell it, the reasons might be:

• You've risen so much;
• You want to put some gains in the bag to make sure you don't lose it all back;
• At this valuation, it may be overvalued and unstable;
• Why not, no one goes bankrupt because of profits.

A: Yes, but on the other hand:

• I'm a long-term investor and I don't think stocks are pieces of paper that can be traded, but as part of business ownership;
• The company still has great potential;
• I can tolerate short-term downside volatility that threatens to create equity opportunities.
• Finally, only the long term is important.

H: But if it's likely to be overvalued in the short term, shouldn't you reduce your holdings and pocket some of the gains? If the stock price falls later:

• You have limited your losses;
• You can also buy at a lower price.

A: If I own shares in a private company with great potential, strong momentum and excellent management, I would never sell a portion of it just because someone gave me a high price.

Good compound interest businesses are hard to find, so letting them go is often a mistake.

Also, I think it's much simpler to predict a company's long-term performance than to predict short-term price movements, and it doesn't make sense to weigh a swing decision in an area you're sure to believe in.

H: Didn't you sell it?

A: Theoretically there is, but it largely depends on:

• Are the fundamentals as I would like;
• Considering how satisfied I am with this current opportunity, are other opportunities similar or better.

Aphorisms like "No one is going to go bankrupt because of profits" may be useful to people who invest part-time for themselves, but they shouldn't have a place in professional investing.

There are certainly good reasons to sell stocks, but they have nothing to do with the fear of making mistakes, feeling regretful, and looking bad. Instead, these reasons should be based on the investment outlook – not the psychology of investors – and must be determined through down-to-earth financial analysis, rigor, and standards.

Stanford University awarded Sidney Cottle the honor of Benjamin Graham and David Cottle. Editor of a later edition of David L. Dodd's Securities Analysis, known as the "Value Investing Bible," included the one I read at Wharton 56 years ago. That's why I called the book Graham, Dodd, and Cato.

Sidney was an advisor to Citibank's investment department in the 1970s, and I'll never forget his description of investment: "the criterion of relative choice." In other words, most portfolio decisions investors make are relative choices.

It is clear that relative selection should play an important role in any decision to sell existing assets.

• If your investment theory doesn't seem as effective as it used to be, and/or the probability of it being verified has dropped, then selling some or all of your holdings may be appropriate.
• Similarly, if another investment that looks more promising emerges – offering a higher expected risk-adjusted return – it makes sense to reduce or empty existing investments to make room for it.

Selling is a decision that cannot be considered in isolation. Sidney's concept of "relative choice" underscores the fact that every trade brings gains.

What would you do with these gains? Is there anything in your mind that you think is likely to bring higher returns? If you move to new investment projects, what will you miss?

If you continued to hold the assets in your portfolio instead of making changes, what would you give up?

Or you may not plan to reinvest. In this case, how likely are you to benefit more from holding cash gains than holding the assets sold?

These questions are related to the concept of "opportunity cost", one of the most important concepts in financial decision-making.

Put another way, if you think there will be a short-term decline in the future that affects the stock you hold or the market as a whole, there are some practical problems with the reason for this sale:

• Why sell stocks that you think are good for your long-term prospects to prepare for what you think is a temporary decline?
• Doing so introduces more wrong paths, as the decline may not happen.
• Munger, vice chairman of Berkshire Hathaway, noted that selling for the purposes of market timing actually gives investors two wrong ways: a fall may or may not happen, and if it does, you have to figure out when the right time is right before you enter.
• There may also be a third, because once you sell, you still have to decide how to deal with the gains, while waiting for the decline to occur and the time is ripe to enter.
• Those who avoid falling by selling frequently may revel in their ingenuity, but will not be able to recover their positions at the resulting lows. As a result, even choosing the right seller may not be able to achieve any lasting value.
• Finally, what if you're wrong and there's no fall? In this case, you will miss the next earnings and either never come back or come back at a higher price.

Therefore, it is usually not a good idea to sell in order to seize the market opportunity. There are few opportunities to profit from doing so, and few people have the skills needed to take advantage of them.

Before I end this topic, it's important to note that the decision to sell isn't always within the control of an investment manager.

Clients can withdraw funds from accounts and funds and thus need to sell, while the limited lifespan of closed-end funds may require fund managers to liquidate their holdings, although they are not yet ripe to sell.

In this case, what to sell still depends on the manager's expectations of future earnings, but the decision not to sell is not among the manager's choices.

How much is "too much" to hold?

Of course, sometimes it is right to sell one asset to support another based on the idea of relative choice. But we can't do that mechanically.

If we do, in a logical extreme case, we will put all our capital into what we think is the best one.

In fact, all investors – even the best – diversify their portfolios.

We may know which way of holding is definitely the best, but I've never heard of an investor who holds only one asset. They may add weight to their favorite assets to take advantage of what they think they know, but they will still diversify to guard against what they don't know.

This means that they have made sub-optimizations, potentially sacrificing some chances of getting the most out of them to increase the likelihood of getting just "excellent gains."

Here's a related question from my conversation with Andrew.

H: Your portfolio is relatively concentrated. XYZ was a big position when you invested, and now it's even bigger considering the appreciation.

Smart investors will concentrate their portfolios and insist on using what they know, but they will diversify their investments and sell when they rise to limit the potential losses caused by what they don't know.

In this regard, will this growth of large positions cause problems for our portfolios?

A: Maybe it's true, it depends on your goals. But reducing positions means selling what I'm happy with based on bottom-up assessments and moving into something (or cash) that I don't feel so good or understood.

It's much better for me to have a small amount of stuff that I feel strongly about. In my lifetime, I'll only have a few good insights, so I have to make the most of the few I have.

All professional investors want to bring good investment performance to their clients, but they also want to achieve financial success themselves. Amateur investors must invest within their risk tolerance.

For these reasons, most investors – and, of course, most of the investment manager's clients – cannot avoid concerns about portfolio concentration, making them vulnerable to adverse developments. These considerations provide justification for limiting the size of purchases and cutting positions when portfolios appreciate.

Investors sometimes delegate decisions about how to weigh assets in a portfolio to a process called portfolio optimization. Enter the potential returns, risks, and correlations of the asset class into a computer model to arrive at a portfolio with the best expected risk-adjusted returns. If one asset appreciates relative to another, the model can be rerun, and it tells you what to buy and what to sell.

The main problem with these models is that all the data we have about these three parameters is related to the past, but to get the ideal portfolio, the model needs to accurately describe the data for the future.

In addition, the model needs to enter a numerical value that represents the risk, and I firmly believe that there is no single number that can fully describe the risk of the asset. Therefore, the optimization model does not successfully determine the performance of the portfolio.

The bottom line is:

• Our investment decisions should be based on our estimate of the potential of each asset.
• We should not sell just because the price is rising and the position is inflated.
• There can be reasonable grounds to limit the size of our positions.
• But there is no way to scientifically calculate what these limits should be.

In other words, the decision to reduce or sell depends on judgment ... Just like other important things in investing.

Some final words about selling

Most investors try to add value by increasing or reducing specific assets, or buying or selling them at the right time.

While few prove capable of doing these things correctly at all times, everyone is free to give it a try.

However, there is a big "but" here.

What I know is that investing is by far the "most important thing". (Someone should have written this book under this title!) ）

Most actively managed portfolios do not outperform the market due to manipulation of portfolio weights or buying and selling for timing purposes. You can try to increase returns by engaging in such "conspiracies," but these operations are unlikely to work in the best case and can be a barrier in the worst case.

Most economies and companies benefit from positive underlying long-term trends, so most securities markets rise in most years and will certainly continue for a long time.

As one of the longest-running stock indices in the United States, the compound average return of the S&P 500 over the past 90 years is estimated at 10.5% per year, meaning that the $1 invested in the S&P 500 index 90 years ago will grow to about $8,000 today.

Many people have talked about the wonder of compound interest, and it is said that Einstein called compound interest "the eighth wonder of the world". If $1 were invested today at a historical compound return of 10.5% per annum, it would grow to $147 in 50 years.

One could argue that economic growth in the coming years will be slower than in the past, or that it will be easier to find cheap stocks than before. Still, even with a compound growth rate of just 7 percent, the $1 invested today will grow to more than $29 in 50 years.

So, in today's adults, if they start investing in time and avoid breaking the process through trading, they can actually guarantee a good fixed income when they retire.

I love what bill Miller, one of the greatest investors of our time, put it in his Third Quarter 2021 Market Letter:

In the postwar period, the U.S. stock market rose about 70% of the time... Odds that are much more unfavorable than this make casino owners very wealthy, yet most investors try to guess when the remaining 30% of the fall will take place, or even worse, they spend time trying to surf the market's quarterly ups and downs, to no avail.

As we recently saw in the recession of the 2020 pandemic, most of the returns in the stock market focused on sharp growth that began in periods of extreme pessimism or fear.

We believe that the key to accumulating wealth in the stock market is time, not timing.

What does Miller mean by "sharp growth"?

On April 11, 2019, The Motley Fool quoted data from JPMorgan Asset Management's 2019 Retirement Guide showing that over the 20 years from 1999 to 2018, the S&P 500 returned 5.6% annually, but if you were indifferent to the best 10 days (or about 0.4% of the trading days), your return would be only 2.0%, and if you missed the best 20 days of the market, you would not make any money at all.

In the past, returns tended to be similarly concentrated in a few days. Still, overactive investors continue to move in and out of the market, creating transaction costs and capital gains taxes and risk missing out on those "sharp outbursts."

As mentioned earlier, investors often sell stocks because they believe a fall is coming and they have the ability to avoid a fall.

The truth, however, is that buying or holding – even at high prices – and experiencing a decline is far from fatal in itself. Usually, every market high is followed by a higher point, after all, only long-term returns matter.

Reducing market exposure through underconsidered sell-offs – and thus failing to fully participate in the long-term positive trends of the market – is a major sin in investing.

This is especially true of selling stocks that have fallen for no reason, turning negative volatility into permanent losses and missing out on the miracle of long-term compound interest.

When people first meet me and find out I'm in an investment business, they often ask "What are you trading?" "This question creeps me out.

To me, "trading" means going in and out of a single asset and the entire market on the basis of guessing the price movements of the next hour, day, month or quarter.

At Oak Capital, we don't do that, and very few people have shown the ability to do it well.

We think of ourselves as investors, not traders.

In my opinion, investing means putting money into the asset based on a reasonable estimate of the asset's potential and benefiting from long-term results.

Oaktree Capital does employ people known as traders, but their job is to execute long-term investment decisions made by portfolio managers based on asset fundamentals.

Here, no one believes that if they sell now and then buy back after the fall, they can make money or promote themselves; they believe that holding for years while fundamental expectations are confirmed will allow value to push up the stock price.

When OakTree Capital was founded in 1995, the five founders — who had been working together for an average of nine years at the time — built on the successes of the time and established an investment philosophy that expressed their views on when buying and selling:

Because we don't believe in the predictive power needed to properly grasp the timing of the market, we keep our portfolio fully invested as long as we can buy assets at attractive prices.

Concerns about the market environment may lead us to lean toward more defensive investments, increased selectivity, or more cautious action, but we never increase our cash holdings because of this.

Clients hire us to invest in specific market niches, and we must not fail to live up to our duties. It is unpleasant to hold an investment with a falling price, but it is unforgivable to miss a return because you did not buy an asset that should have been bought.

We've never changed the six principles of our investment philosophy — including this one — and we have no plans to do so.

January 13, 2022

Translator's Note

OakTree Capital's six investment principles:

• Risk control is paramount

Our goal is not to achieve superior investment performance, but to achieve excellent performance in the face of risk asymmetry. Getting above-average returns in good years is not necessarily proof of a fund manager's ability; proving that these "good years" gains are earned through ability requires excellence in downturns.

Therefore, we do not just look for potential profits, but put the prevention of losses in the highest priority. Especially in the opportunistic market in which we live, our strongest belief is: "If we avoid being the loser, we will naturally become the winner." ”

• stability

We cannot accept performance fluctuating back and forth between the best and the worst. We believe that a good track record is best built on a high success rate than a combination of success and failure.

• Look for markets that are not fully efficient

We believe that technology and hard work can lead to a "knowledge advantage" that may lead to better investment outcomes. But we don't think that's going to happen in the so-called efficient market.

In efficient markets, a large number of participants share roughly equal information and incorporate information into asset prices in an impartial manner. We believe that the application of skills and effort should pay off for our customers in some less efficient markets where we will only invest.

• specialization

Specialization provides the most reliable path for the results we and our clients seek. Therefore, we insist that each portfolio invests only in a single area and is absolutely the best. We set guidelines for each investment direction as clearly as possible and do not deviate from them. That way there won't be surprises (or scares).

The provision of a professional portfolio will enable clients interested in a single asset class to obtain the investment solutions they want, and clients interested in multiple categories can also combine our investment solutions into the combination they want.

• Macro forecasts are not important for investment

We believe that consistently excellent performance can only be achieved through a deep understanding of the company, rather than trying to predict the future economy, interest rates or securities markets. As a result, our investment process is entirely bottom-up and based on specialized, company-specific research. We use the overall portfolio structure as a defensive tool to help us avoid potentially dangerous concentrations, rather than a weapon that allows us to hold more of our best investments.

• Negative timing

Because we don't believe in the predictive power needed to properly grasp the timing of the market, we keep our portfolio fully invested as long as we can buy assets at attractive prices. Concerns about the market environment may lead us to lean toward more defensive investments, increased selectivity, or more cautious action, but we never increase our cash holdings because of this.

This article is from Wall Street Insights, welcome to download the APP to see more