"Selling your winners and holding your losers is like cutting the flowers and watering the weeds" is probably one of Peter Lynch's most famous quotes. It packs a lot of wisdom in a relatively small number of words. It's so good that even Warren Buffett (Trades, Portfolio) of Berkshire Hathaway Inc (BRK.A, Financial) (BRK.B, Financial) called Lynch to ask if he could use the quote.
Lynch's investment strategy
As one of the most successful mutual fund managers of all time, Lynch understands a thing or two about investing. During his 13-year tenure managing the Magellan Fund at Fidelity Investments in the 1980s, Lynch achieved a remarkable 29% average annual return – more than doubling the S&P 500.
Lynch did not achieve these spectacular results through luck or fancy financial models. His approach was simple – invest in what you know and let your winners run. While this sounds easy, most investors fail to follow this simple formula. Instead, they tend to sell their biggest winners early while clinging to their losers.
Cutting the flowers while watering the weeds
Lynch coined the phrase "cutting the flowers and watering the weeds" to describe this common yet detrimental investing mistake. When a stock increases substantially, investors get nervous and lock in gains by selling the stock. At the same time, they hang on to poor performers, hoping they will rebound.
This inclination to sell winners and hold losers seems completely illogical. After all, the winners have demonstrated strong potential. Why not let them continue compounding returns? Meanwhile, the losers keep dragging down overall portfolio performance. Would not it make more sense to cut them loose?
Emotions over reason
Yet Lynch realized most investors let emotions rather than reason drive their decision-making. People fear losing the large gains they have accumulated, so they sell winners. Meanwhile, selling losers at a loss is psychologically painful, so investors postpone the decision even when logic dictates otherwise.
By cutting the flowers, investors forfeit the opportunity to let their highest potential stocks keep flourishing. At the same time, watering the weeds wastes precious time and capital on lackluster investments. This irrational behavior exacts a heavy toll on overall returns.
The high cost of selling too soon
Several studies have quantified the damage done by selling winners prematurely. Dalbar published a report showing that during the 30-year period ending in 2016, the S&P 500 returned 10.16% annually. However, the average equity fund investor earned only 3.98%. What accounted for the staggering annual difference? It mainly stemmed from poor timing decisions like selling winners and holding losers.
Impact of investor behavior
Fidelity also conducted a similar analysis with its Magellan Fund. An investor who bought and held the fund from 1977 to 1990 would have averaged a 29% return under Lynch's management. In reality, the average Magellan investor lost money during that same period. Again, investor behavior was largely to blame.
Lynch himself acknowledged this problem, stating his biggest mistakes were selling winners, like The Home Depot Inc. (HD, Financial) and Walmart Inc. (WMT, Financial), too early. Both stocks multiplied in value for years after he sold them. At Berkshire Hathaway, Buffett and Charlie Munger (Trades, Portfolio) have encouraged a buy-and-hold approach, rarely selling stocks. Doing so allows their winners to grow unimpeded for decades.
Why investors struggle to hold winners
If selling winners too soon is clearly detrimental, why is it so rampant? It boils down to how the human mind works. Academics in the field of behavioral finance have identified several biases that cause investors to sell prematurely.
One of them is loss aversion. People prefer avoiding losses over making equivalent gains. After a stock has gained substantially, investors grow anxious about giving back those returns. This results in a bias toward locking in the sure gain rather than risking further upside.
Investors also tend to anchor to the price at which they bought the stock. Once the stock reaches the anchor point, the investor is inclined to sell regardless of business fundamentals.
Additionally, when investors purchase a stock, they typically underestimate its future growth potential. So after doubling or tripling in value, they presume the growth is played out even if much runway remains.
Another bias is overconfidence. If a stock falls after an investor buys it, they are inclined to attribute the decline to external factors rather than flaws in their analysis. This results in holding losers for too long.
Representativeness is also a factor. Investors expect all stocks to behave in similar ways. They may prematurely sell a winner that does not adhere to an arbitrary definition of how a stock "should" perform.
Then there is regret aversion. Selling winners may cause regret if the stock continues rising. However, investors feel justified holding an unrealized loss since they have not locked in the mistake yet.
Mental accounting is another issue. Investors tend to place arbitrary valuations on stocks tied to the purchase price rather than business fundamentals. Once a stock reaches the predetermined target, they sell.
Finally, there is availability bias. After a long bull market, investors grow overly fearful of a coming downturn. This tempts them to sell winners and remain in cash rather than stay invested.
Implementing Lynch's advice
Fortunately, investors can overcome these detrimental biases by following Lynch's sage advice on holding winners. Here are some tips:
- Invest in companies you understand: Thoroughly research a business and its growth prospects before investing. This knowledge helps investors stay resolved when the stock appreciates.
- Define sell criteria upfront: Determine valuation thresholds, fundamental changes or technical signals that would trigger a sale before investing rather than making abrupt calls in the midst of holding a winner.
- Set price alerts: Instead of watching a stock tick-by-tick, set alerts at logical price milestones to signal when fundamental analysis should occur to validate continuing to hold.
- Size positions appropriately: Do not let a single stock become too large a percentage of the overall portfolio. This helps mute the psychological impacts of volatility within one holding.
- Remember business fundamentals: Separate stock price changes from underlying business results. Do notbe tempted to sell only because of share price fluctuations.
- Track gains as a percentage: Viewing returns in raw dollars makes gains seem larger and promotes selling. Convert to percentage gains to aid rational decision-making.
- Avoid market timing: Making market calls is futile. Assume long-term bull markets remain intact unless concrete evidence proves otherwise. Do not sell quality stocks based just on short-term volatility.
- Have a sounding board: Bounce sale decisions off a mentor or objective third party. Fresh perspectives help overcome biases clouding judgment.
- Learn from experience: Keep a journal tracking situations that caused premature selling. Review it to identify personal biases.
When to sell a stock
There are, of course, valid reasons to sell a stock that has appreciated significantly. However, these should relate to fundamentals – such as the company losing its competitive edge, increased regulatory risk, saturation of its core market or excessive valuation relative to realistic growth projections.
Selling simply because the share price rose rapidly introduces unnecessary risk. Instead, allow quality stocks time to flourish. Remain calm amid volatility, reviewing the initial reasons for purchasing. Sell only when concrete evidence demonstrates the investment thesis no longer holds.
Avoid the temptation to sell too soon
Selling winners and holding losers is an all-too-common investing mistake. It stems from mental biases that cause investors to act irrationally and forfeit returns. However, by understanding why this tendency manifests itself, investors can overcome it.
Stick to a disciplined selling framework focused on fundamentals rather than emotions. Ignore arbitrary price anchors that trigger selling due to a fixation on the purchase price. Let many years pass before concluding that a growth story has run its course. Investors who successfully avoid the temptation to sell winners too early have the opportunity to generate life-changing wealth through the power of compounding.
