Why You Should Sell

I can be just as dumb as anybody else. -- Peter Lynch, September 2008

Peter Lynch earned near-30% annual returns running Fidelity Magellan
from 1977 to 1990. He's sold millions of books, raised millions for
charity, and holds the rare distinction of having a Motley Fool Global
HQ conference room named after him.

But in September 2008, Peter Lynch also had the ignominious honor of holding both AIG and Fannie Mae in his personal portfolio -- as they dropped 82% and 76%, respectively, during that month alone.

Ouch.

For those of us who have spent our investing careers trying to match
the great Peter Lynch … well, if you lost 80% in September, then
congratulations -- you did it! If you did better than negative 80%,
then you beat the great Peter Lynch.

Invest like Peter Lynch
We kid, of course, and
we're in no way demeaning Lynch or his illustrious career. Rather,
we're just pointing out how hard it's been to avoid a flameout lately.
Indeed, the once-revered Bill Miller's Legg Mason Value Trust lost more than 55% last year, when big  holdings Citigroup (NYSE: C), General Electric (NYSE: GE), and Eastman Kodak (NYSE: EK) were hit hard. Hey, when the blue-chip S&P 500 has dropped some 40% over the course of a year, you know it's bad.

And when companies like Texas Instruments (NYSE: TXN) and Rockwell Automation
(NYSE: ROK) drop more than 50% in the course of a year -- even though
they're historically strong operators that appear to have little to do
with the crisis on Wall Street -- you know it's rough out there for
pretty much everyone.

In other words, even if you don't own AIG or Fannie, you probably own a stock like AIG or Fannie. We sure do. Brian, for example, has ridden SunTrust Banks from $60 to $14, while Tim has watched HDFC Bank (NYSE: HDB) drop from $120 to $70. Ahem.

We are not alone
And while there are many
stocks that will recover from this market downturn, it's likely we're
all continuing to hold stocks that won't. New research, from Professors
Nicholas Barberis and Wei Xiong of Yale and Princeton Universities,
gives a name for this tendency. We're exhibiting "realization utility."

Realization utility encourages investors to hang on to stocks that
have sunk -- even when those stocks have dim futures. Here's how they
explain it:

The authors consider an additional experimental condition in which
the experimenter liquidates subjects' holdings and then tells them that
they are free to reinvest the proceeds in any way they like. If
subjects were holding on to their losing stocks because they thought
that these stocks would rebound, we would expect them to re-establish
their positions in these losing stocks. In fact, subjects do not re-establish these positions.

That's right. If we force-sold all of your stocks and gave you the
cash to reinvest, would you buy the stocks we had just sold? Odds are,
you wouldn't.

So, why would you hold on to stocks that you don't think will recover? We'll let the good professors give it to you straight:

Subjects were refusing to sell their losers simply because it would
have been painful to do so … subjects were relieved when the
experimenter intervened and did it for them.

Wait a second
But aren't we the guys who pounded the table
two years ago about how individual investors like us sell winners too
early, missing out on life-changing multibagger gains to lock in a
modest return? "Quick trigger fingers aren't rewarded," we wrote at the
time.

And that's still true. But down markets like this one present an
enormous long-term opportunity for investors … only so long as you're
willing to do some selling.

See, when stocks are expensive, we may invest in mediocre stocks
because they look cheap, while passing on superior operators because
they're too expensive. Today, however, those superior operators are all
down double digits at least.

Stalwart Disney (NYSE: DIS) -- with its FCF-generating abilities and global brand dominance -- has a P/E in the single digits!

In other words, now is the time to upgrade your portfolio.

Why you should sell
You should always sell when
you have a better place to put your money -- and today, a host of
superior companies are on sale. The takeaway, then, is to recognize
when realization utility may take root, take a sober view of your
holdings, and take advantage of this down market to upgrade your
portfolio. Ten years from now, you'll be very glad you did.

We're both looking to take advantage of current prices
in foreign markets -- which have been hammered even worse than our own
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This article was first published Feb. 20, 2009. It has been updated.

Brian Richards owns shares of SunTrust (still). Global Gains co-advisor Tim Hanson owns HDFC Bank, which is a Global Gains recommendation. Disney is a Stock Advisor and an Inside Value recommendation. The Motley Fool has a disclosure policy

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