Stock entry and exit decisions need to work in tandem, and in a disciplined manner to create a robust portfolio, thereby increasing the probability of generating good returns
In Indian Puranas, Vaikunta’s (God’s heavenly abode) gates are guarded by two gatekeepers – Jaya and Vijaya. They screen visitors who come for the darshan of Lord Vishnu.
Now, we use the gatekeepers as a metaphor to create a mental model of ‘buy and sell’ discipline for an investor’s portfolio. For our model, let’s visualize an investor’s portfolio as a room with two doors, the entry and the exit. We will put a guard at each door. Let’s name the two guards – Nivesh (investment), standing at the entry and, Vinivesh (disinvestment), guarding the exit. While Jaya and Vijaya are synonyms, Nivesh and Vinivesh are antonyms.
The “buy” discipline (nivesh)
The buy discipline reflects the investment philosophy of the investor. The main job of this gatekeeper is making intelligent and disciplined selection. Nivesh, standing at the entry door, has two important decisions to make: what to buy (who qualifies to get in) and when to buy (when to allow entry). He has to actively scout for ideas in the market that match with the investment philosophy. The parameters for screening should be economically sound, after considering those investment principles that have historically delivered healthy returns for the investors. Nivesh may arrive at an investible universe by either a top-down approach or using a combination of qualitative and quantitative screeners based on some micro or firm-based parameters.
Sifting through business fundamentals, Nivesh identifies who he would like to invite inside. But he still has to figure out when to allow the entry. On one side of the risk curve, there are companies that you want to avoid for being extremely risky, which are easier to identify. On the other side of the curve, there are companies that may be perceived as being extremely safe and as a result may be available at a price that doesn’t deliver good returns to investors.
When would a company that is attractive in terms of business fundamentals be available at a reasonable valuation? The few reasons such opportunities come up are:
– Good companies often undergo a short-term decline in business prospects. The crowd may either stay away from such companies or actively sell them from their portfolio.
-The stock price of a company can become undeservedly low due to the over-reaction to a negative development. Also, new investors may not want to catch a falling knife.
-Markets frequently underestimate the longevity or the strength of a company’s competitive advantage and some investors sell them cheap.
Timing of purchase hence requires an understanding of behavioural aspects of the crowd, along with the knowledge of valuations.
The problems for Nivesh arise if he deviates from the disciplined approach to accommodate the investments that would otherwise not qualify. This can happen due to:
-Accommodating a company in the portfolio out of fear of missing out
-Impatience while completing due-diligence
-Paying the wrong price
Vinivesh forces the hand of Nivesh at times. This happens when investors sell something and are too worried about sitting on cash.
The sell discipline (Vinivesh)
Vinivesh has an equally important job as Nivesh. Unfortunately, he gets much less attention than Nivesh in investment literature. One of the reasons could be that investors take pride in long-term horizons and holding periods. However, high competition, technology changes and shortening business cycles can hurt “buy and hold” investments.
Typically, investors trim or fully sell an investment because:
-It becomes a large part of the portfolio
-A stop loss level is hit
-Stock price reaches a target level or valuation
-Adverse change in company fundamentals
-Availability of a replacement
Ideally, valuation alone should not be a reason to sell an investment. The sell discipline is likely to deliver better results when high valuations are combined with another factor to trigger a sell.
Vinivesh also gives feedback to Nivesh about how his process is performed. But Vinivesh is vulnerable to making two mistakes: a) Holding on to losers for too long, and b) Exiting winners too early. They can be best understood when observed from the behavioural angle.
-Loss aversion: Investors love to take profits, but hate to book a loss, which is psychologically more painful.
-Cognitive dissonance: The reason for buying a security is invalidated but investors rationalise to continue to hold it
