Should an investor sell a good stock in the face of a potentially bad market? Now more than ever, the actions of the people who invest in stocks appear to reflect the belief that when an investor has achieved a good profit in a stock and fears that the stock might well go down, he should grab his profit and get out.
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My view is rather different. Even if the stock of a particular company seems at or near a temporary peak and that a sizable decline may strike in the near future, I will not sell a firm's shares provided that I believe that its longer term future is sufficiently attractive. I prefer to hold.
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My belief stems from some rather fundamental considerations about the nature of the investment process. Companies with truly unusual prospects for appreciation are quite hard to find for there are not too many of them. However, for someone who understands and applies sound fundamentals, I believe that a truly outstanding company can be differentiated from a run-of-the-mill company almost 90% of the time.
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It is vastly much more difficult to forecast what a particular stock is going to do in the next 6 months. Yet people's forecasting record predicting changes in the business cycle has generally been abysmal. They can seriously misjudge if and when recessions may occur, and are worse in predicting their severity and duration.
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Furthermore, neither the stock market as a whole nor the course of any particular stock tends to move in close parallel with the business climate. Changes in mass psychology and in how the financial community as a whole decides to appraise the outlook either for businesses in general or for a particular stock can have overriding importance and can vary almost unpredictably.
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For these reasons, I believe that it is hard to be correct in forecasting the short-term movement of stocks more than 60% of the time no matter how dilligently the skill cultivated. On the face of it, it doesn't make good sense to step out of a position where you have a 90% probability of being correct because of influence about which you might have at best a 60% chance of being right.
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Moreover, for those seeking major gains through long-term investments, the odds of winning are not the only consideration. If the company is well-run with sufficient financial strength, even the greatest bear market will not erase the value of holding. In contrast, time after time, truly unusual stock have subsequent peaks many hundreds of percent above their previous peaks.
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So putting it in the simplest mathematical terms, both the odds and the risk/reward considerations favor holding. There is a much greater chance of being wrong in estimating short-term adverse changes for a good stock than in projecting is strong long-term price appreciation potential. If you stay with the right stocks through even major temporary market drops, you are at most going to be temporarily behind the former peak at the very worst point and will ultimately be ahead.
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However, the underlying presumption is that the investor is able to differentiate a truly outstanding company from a stock market darling. Investors who are not able to differentiate between them will not be suited for this strategy at all. One will truly have to be able to tell a MacDonald's and Coca -Cola from a General Motors and AIG.
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Whereas if you sell and don't buy back you will have missed long-term profits many times the short-term gains from having sold the stock in anticipation of a short-term reversal. It is so difficult to time correctly the near-term price movements of an attractive stock that the profits made in the few instances when this stock is old and subsequently replaced at significantly lower prices are dwarfed by the profits lost when the timing is wrong. Many will sell too soon and have either never gotten back in or have postponed reinvestment too long to recapture the profits possible.
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Therefore, in and out, may be out of money. It is important to note that even if the anticipated big drop were to occur it might still be higher than the price that you were so eager to sell.
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After a sharp advance, a stock nearly always looks too high to the financially untrained. This demonstrated the risk to those who follow the practice of selling shares that still have unusual growth prospects simply because they have realized a good gain and the stock appears temporarily overpriced. These investors seldom buy back at higher prices when they are wrong and lose out on further gains which are of dramatic proportions.
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At the risk of being repetitious, let me underscore my belief that the short-term price movements are inherently tricky to predict and that I do not believe that it is possible to play the in and out game and still make enormous profits that have accrued again and again to the truly long-term investor in the right stocks.
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Then what about those rare years when speculative buying is running riot in the stock market and major economic storm signals are virtually screaming their catastrophic warnings? How do we know that we are not being seduced by the excitement of times into paying unrealistic prices? What should the long-term investor do under such circumstances? This will be the main topic for the subsequent post.
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