Over the past six months, the world has changed dramatically. The coronavirus crisis has upended how we work, interact with each other and our daily lives. Some of these changes may not last long, but others may be here to say, meaning that investors should approach the stock market with caution.
A challenging environment
This is a challenging environment for investors. Companies that appeared to be great businesses at the beginning of the year are now fighting for survival. Some will recover, others won't. There are so many variables. It's difficult to tell at this stage which companies will succeed and which won't.
In this environment, we must be aware of the psychological bias of loss aversion. In behavioral economics, loss aversion refers to people's preferences to avoid losing compared to gaining equivalent amounts. To put it another way, investors will avoid taking a loss now even though doing so may lead to higher returns in the long run. In the current environment, a good example would be selling a stock that's struggling in the pandemic in favor of one that's registering higher growth.
This comes back to the problem of when to sell a security. Answering this question is far harder than deciding when to buy. Loss aversion is just one of the many factors that can influence a decision to sell. The fear of missing out on future gains can also influence this critical decision.
There is no guide to which investors can refer when trying to establish the right time to sell. There's also no guide investors can use to avoid psychological bias. Nonetheless, by being aware of these problems, it's easier to get around them. Doing so may help in the process of deciding when to sell.
When to sell a stock
According to Warren Buffett (Trades, Portfolio), there are two reasons to sell a stock. The first is if something better turns up. The second is if the facts change.
As mentioned above, in the current environment, it's difficult to predict market winners and losers over the next few years. Still, it's clear that many companies will face a harder operating environment in the medium term.
Companies such as airlines and cruise ship operators may not see demand return to 2019 levels until the middle of this decade. That suggests the situation has changed for these businesses, and when they do recover, there's no guarantee they'll be in one piece.
Meanwhile, the tech sector trends that have been developing over the past decade have accelerated in the past six months. Business models have been destroyed while others have grown. This abrupt change in company prospects may mean investors are better off selling some old-world companies and investing in new world businesses. This would meet the "when facts change" as well as the "if something better turns up" criteria.
The bottom line
All in all, now could be a good time for investors to re-evaluate their portfolios. The world has changed over the past six months, and some companies may never recover from the crisis. If the facts have changed for a business, it's time to change the position.
It is all too easy to say that the situation will be different a year or two from now, but that may not necessarily be the case. That's why it's essential to take an objective view of positions and seek disconfirming evidence.
This process isn't easy, but investors must be realistic and question their ideas in these trying times. Holding on for better times should not be an option if the facts have changed or if there's a company out there with brighter prospects.
Disclosure: The author owns no share mentioned.
Read more here:
- Seth Klarman's 3-Stage Approach to Valuation
- Is Price-Book Ratio Still Relevant for Value Investors?
- Buffett Adds to Bank of America: More Deals on the Way?
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