Saturday, December 13, 2014

When to Throw in the Towel on a Stock

In Morgan Housel's excellent article, "If Other Industries Were Like Wall Street", he shares this satirical story: 
If we were as impatient about gardening as we are investing: Sam plants some seeds in his backyard. He checks back four hours later. Nothing. He digs them up and replants them. Four hours. Still nothing. A week later he is dismayed that he has no oak trees in his backyard. He calls oak trees a scam.
As Homer Simpson says, "It's funny 'cause it's true." 
Shoulda thrown in the towel. George Bellows' "Dempsey & Firpo"

It's equally irrational, however, to plant some seeds in the backyard, check back a decade later, see nothing sprouting from the ground, yet conclude an oak tree will eventually emerge. Something went wrong. 

At some point between the two extremes - four hours and a decade - it makes sense to throw in the towel on a stock that isn't performing and reinvest the capital elsewhere.

But how do we determine the right time? 

Here's Philip Fisher's opinion on the matter, from Developing an Investment Philosophy:
It was vital that I have some sort of quantitative check to be sure that I was right...With this in mind, I established what I called my three-year rule...
Whether I have been successful in the first year or unsuccessful can be as much a matter of luck as anything else...If I have a deep conviction about a stock that has not performed by the end of three years, I will sell it. If this same stock has performed worse rather than better than the market for a year or two, I won't like it. However, assuming that nothing has happened to change my original view of the company, I will continue to hold it for three years.  
Indeed, one of the "ground rules" of Warren Buffett's partnership was:
While I much prefer a five-year test, I feel three years is an absolute minimum for judging performance...If any three-year or longer period produces poor results, we all should start looking for other places to have our money. 
Three years seems like the right amount of time to give the market a chance to come around to your thesis. If that hasn't happened by the three year mark, your thesis was probably wrong. 

There's something to be said for taking the "coffee can" approach -- investing in a stock and then checking back on it many decades later. Fidelity reportedly ran a study, for instance, that found the group of its clients who had the best performance were those who forgot they had accounts at Fidelity.

If given the choice of doing nothing or trading my portfolio every month, I'd choose the do nothing approach. In practice, the ideal strategy is found somewhere in the middle. 

The key is that your decision-making rules are long term in nature and are approached with a patient, business-owner's mindset. A three-year rule for throwing in the towel on a poor investment is one such rule that we'd do well to implement in our process. 

This is the last Clear Eyes Investing post of 2014. Thank you very much for reading this year. Hoping you have a wonderful holiday season!

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Stay patient, stay focused.