February 19, 2021

20% profit - should I sell?

An Obermatt Premium user asked recently if it is correct to sell stock after they made a 20% profit. The idea is compelling: “Make the money and run,” as Dr. Stern's New York godfather likes to say. Does this make sense?

People think stock prices are a good indicator of performance. But they are not. Stock prices reflect only the future, not the past and are therefore indicators of judgements much more than performance.

This isn’t easy to grab.

Let’s assume that a company fundamentally became 20% better over a certain period of time. Let’s assume that this is known by the end of this period and the stock price is 20% higher. Will it have moved there smoothly, with small steps at a time?

You actually can’t tell. If the investors expected that performance improvement at the beginning of the period, the stock price would have reacted immediately. It would jump +20% and stay there until the end of the period (for the techies: assuming the dividends provide the expected asset class return). If the investors didn’t expect that improvement and were surprised to see it at the end of the period, the stock price would have remained flat while the company got better and better and then only reacted at the end of the period by jumping the required +20%.

Most humans, including Obermatt CEO Dr. Hermann J. Stern as an economist student, expect stock prices to move step by step, smoothly, to reflect the underlying performance of the company during that time. But this case is actually quite rare. As soon as the first little performance surprise becomes visible, e.g. the first 2% of the 20% of the performance improvement, markets tend to extrapolate into the future and push the stock price much more than justified by the current first step performance.

Everything else would be irrational. Why wait until the performance actually happens? Why not buy the stock immediately and benefit from the performance? This purchasing behaviour makes stocks jump right when expectations change - irrelevant of underlying performance.

Of course, expectations change all the time. The Nobel Prize winner Robert Shiller could prove that market expectations fluctuate far more than the companies behind the shares and that they can be wrong for many, many years, easily a decade.

What does this mean for using past returns as an indicator for selling a stock?

It’s irrelevant. If the +20% are justified by higher profits, changing future expectations or correcting false past expectations, there is no reason to sell (the differing view is the momentum investor community that the economist in me despises).

Are there any other sell signals? No, neither bad news nor analyst recommendations are good reasons because they all have to maintain their reputation and therefore stay well within what is generally accepted and thus reflected in current stock prices.

Selling is personal, just like buying. If you need the money, sell. If you need to save money, buy. If you want to consume more and don't have cash, sell stocks. If you want to invest someplace else, in another stock or a new home, sell stocks. If you have stocks that you don’t want anymore, maybe because they are just an administrative nuisance because they fell too much in value, sell stocks to clean your portfolio up. Otherwise, keep your investments. What else should you do with your money?

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