In William Shakespeare’s Hamlet, there is a famous speech by Hamlet where he is trying to decide whether it is better to live or die by suicide. He discusses how painful life can be, and how death would be preferable, would it not be for the fearful uncertainty of what comes after death.
Investors agonize over the thought of selling a profitable position, paying taxes, and of missing out on future gains. They are also fearful of keeping the position and potentially having the stock go down in value. Like Hamlet fears what comes after death, the investor can be paralyzed by the fear of what the future may bring.
The Crystal Ball, Tarot Cards, Palm Reading
Nate Silver, in his book, The Signal and the Noise, reported on a study he did on the accuracy of the Survey of Professional Forecasters dating back to 1968. What he found was that the actual figure for GDP fell outside the prediction interval almost half the time. The prediction interval is the range in which the forecaster believes 90 percent of the outcomes will exist. This means they believe there is only a 10 percent chance the outcome would happen outside their prediction interval. In actuality, the outcomes happened outside their range 50 percent of the time. What they found out was the margin of error for the forecasters was 3.2 percent. This means if they predicted 2 percent growth, it would be just as likely the growth would come in at negative 1.2 percent growth.
James Montier, in his book, Value Investing, reported on a study done by Rui Antunes on the accuracy of predictions made by Wall Street analysts. What he found was not very flattering. The average forecast error for two-year predictions was 94 percent. The average forecast error for one-year predictions was 47 percent. This makes their one-year predictions not much better than the flip of a coin.
When someone in a prominent position tries to tell you what the future will be, regardless of what their profession may be, find out how accurate they have been in the past. Rarely will you find someone who will publish their bad calls.
Promoters try to tell you what the future will look like. They do this mostly to create a narrative from which they will benefit. Professionals will give you likely outcomes, based on a large data sample, choosing the most likely outcome, and preparing you for the unlikely outcome.
Lao Tzu, a famous Chinese philosopher, had the famous quote, “Those who have knowledge don’t predict, and those who predict don’t have knowledge.”
Mathematical Psychology
Daniel Bernoulli was one of the greatest mathematicians of the 18th century. He was famous for his works on risk and probability. In 1738, Bernoulli stated “The utility from a small increase in wealth will be inversely proportionate to the quantity of goods previously possessed, that there is no reason to assume that the risks anticipated by each individual must be deemed equal in value.” For example, someone who has just won the lottery is more likely to take on a low probability outcome with a high payout than a person who has just lost most of their wealth in the stock market. What this landmark research introduces is the idea that subjective outcomes need to be calculated along with quantitative outcomes.
This research was expanded upon by Amos Tversky and Daniel Kahneman in their paper titled “Prospect Theory; An Analysis of Decisions Under Risk”, in 1979. This paper was cited when Kahneman won the Nobel Prize in 2002. What this paper did was show how investors react to losses. For example, two different investment advisors promote the same investment. The first advisor states the investment has had an average return of 10 percent over the last ten years. The second advisor states the investment has had an above average return, however, it has lost money in the last three years. The investor is more likely to purchase from the first advisor, according to the research in this paper.
Investors can react differently whether the losses are from unrealized gains or destruction of wealth. Roy Raymond jumped off the Golden Gate bridge when the company he sold for $4 million became worth billions. The name of that company was Victoria’s Secret. Adolf Merckle drove his car on to a train track and waited for a train to run over him after losing billions in the financial crisis of 2008. These are extreme examples of people who took their lives because they didn’t understand the reasons they made or lost their money in the first place.
Trying to make a decision on the outcome of a present investment should involve the probable mathematical outcomes along with the subjective psychological outcomes related to each investor.
Taxes
Most investors agonize paying taxes on a successful investment. The current tax rate on capital gains for married couples making less the $553,850 is 15 percent, according to IRS Topic no. 409.
For example, Nvidia today trades at $135 a share. If one year ago you bought 1,000 shares at the price of $42, split adjusted, your profit would be $93,000. If you sold the shares, your tax liability would be $13,900. This will leave you with the net gain of $79,050 on a $42,000 investment.
If the investor holds the stock and does not sell, and the price drops more than 11 percent, the investor has lost the amount which would have paid the taxes and continues to have the tax liability on the reduced gain.
One other consideration is the current tax rate. Capital gains taxes are historically low. During the seventies, the tax on capital gains was 35 percent. If Congress decides to try and raise taxes to reduce deficits and debt, raising the capital gains rate could be the first target.
The Decision
Trying to decide whether to keep the position or sell and harvest the profits should involve a process which can prevent the investor from making a biased decision. When trying to decide whether to keep or sell, I ask myself what the reasons were for originally investing in the company. Did the company have some proprietary new product? Did the company have a temporary adverse event which drove valuations to unreasonably low levels?
If the company had developed some new revolutionary product, how long would it be before competition erodes their market dominance? If the competition challenges their market share, could the price of the stock fall materially?
If the company had fallen to unrealistic valuations, how do the current valuations compare to long-term averages? What are the realistic expectations for the price of the stock at mean valuation levels?
Investors would also need to examine external risks, such as geopolitical risks, regulatory risks, and supply risks.
These are the quantitative reasons. Next, we need to examine the psychological challenges. It is human nature to feel a sense of satisfaction from owning a stock which has a huge gain. The problem comes when this one position starts to dominate how you evaluate performance.
When the reasons for buying the successful stock were subjective, the investor may not want to realize the actual level of luck that was involved in the success. If this is the case and the stock goes up in price substantially after they sell, it may be difficult to accept. If the stock goes down in price after they sell, they continue their lucky streak.
When the reasons for buying the successful stock are based on logical methods, the methods have been rewarded. When you sell the stock for a nice profit, there is comfort in knowing the method can be replicated in future situations. If the stock price rises after the sell, others are relying on luck to carry them through.
Conclusion
There is no such thing as the perfect sell or the perfect buy. It is only by luck a person can buy the lows or sell the highs. If someone playing Blackjack at a casino decides to hit 17 and gets a 4, that doesn’t make them a good Blackjack player. It means they are lucky.
The best investors understand market prices are determined by participants with wide ranges of decision processes. The closing price of a stock made by a person who traded 100 shares rarely reflects what the majority believes is the actual value of the company. What will work over a complete investing career is to choose sound logical methods for making decisions and ignore the negative emotions when outcomes are not optimal.
Notes and Disclaimers
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