Ep 65: When To Sell An Underperforming Investment

Ep 65: When To Sell An Underperforming Investment

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The Smart Take:

Inevitably you will have some investments perform better than others in your portfolio. A normal, human response is to seek pleasure and avoid pain or sell the underperformer and buy what has done well. But does that make investing sense?

Listen to Kevin discuss why underperformance is often confused with an asset class being out of favor. Learn about critical concepts of diversification, probability and why process matters more than outcomes (in the short term).
Hear an example of this being applied to guarding Kobe Bryant in professional basketball and playing probabilities in blackjack.
In sticking to a good process, good outcomes are more likely to result. In focusing on outcomes, you are more at risk of stampeding over the cliff with the uninformed herd and wrecking retirement.

Check the four-part Your Investing Process Series, mentioned in this episode:





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0:43 – Defining Underperforming Investments

2:12 – Is The Investment Or Asset Class Underperforming?

4:32 – Metrics To Consider When Choosing Investments

6:57 – Getting Rid Of Underperforming Stocks

8:35 – Terminal Wealth Dispersion

12:32 – People Don’t Invest Rationally

14:47 – Using Probability In Your Favor

20:38 – Planning For Different Outcomes


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The Host:

Kevin Kroskey – AboutContact

Intro:                                     Welcome to Retire Smarter with Kevin Kroskey. Find answers to your toughest questions and get educated about the financial world. It’s time to retire smarter.

Walter Storholt:                It’s time for another edition of Retire Smarter. Walter Storholt, alongside Kevin Kroskey, President and Wealth Advisor at True Wealth Design, serving you in Northeast Ohio, the Greater Pittsburgh area, and in Southwest Florida. If you’d like to get in touch, you can always do that by going to TrueWealthDesign.com and click the Are We Right For You? button. On today’s show, we’re going to pretend that I’ve lost thousands of dollars in a terrible investment, and I’m sitting with the big negatives in red on my stock and market tracking screens here, Kevin. And I just don’t know if I should hold these underperforming investments and stay the course, or at some point, do I need to cut and run? And I know that you’ve probably helped navigate people through this situation before.

Kevin Kroskey:                  Yeah, it could be red, but you could also have, say, two investments, maybe one’s just doing a lot better than the other one, so they could both be green.

Walter Storholt:                So your underperforming definition is not necessarily lost money?

Kevin Kroskey:                  Correct. Absolutely correct. So yeah, this is something that I mean, we always have to ask ourselves as we’re doing just our investment work. One, is it something that makes sense to own? And then two, is it doing what it should be doing? But when you hear something like this, and we’ll talk about diversification in a bit, but I always like to quip that anytime that you look at your investment portfolio, you should probably be unhappy with something that you’re looking at. If you’re truly diversified, which we’ll talk about the benefits of it in a little bit, not everything is going to be moving in concert with one another. At least, it should not be. So-

Walter Storholt:                I never thought of it that way, but that makes a lot of sense. That goes very against human nature, though, doesn’t it?

Kevin Kroskey:                  Yeah. I mean, if you did see the green and red example that you started with, of course, give me more green. I don’t like that red, right?

Walter Storholt:                That’s right.

Kevin Kroskey:                  It doesn’t take a rocket scientist to figure that one out. But the thing that I would say is, is it the investment or is it the asset class? So, the investment itself, think of like the S&P 500. So that’s an investment. The asset class that attracts is really large US stocks. There’s a mix of growth stocks and value stocks, but it’s generally about the 500 largest US stocks, all equally weighted between growth and value and a blend.

So that’s just one asset class. It doesn’t include small US companies. It doesn’t include small value companies. It doesn’t include international companies or real estate or anything like that. So when you think of the tech bubble. So the years 2000 through 2009 were considered the lost decade by many, and the S&P 500 actually had negative returns for the entire ten years. Does that mean that the S&P 500 Index Fund was a bad investment? I would say no. If you think of a vanguard S&P 500 Index Fund, I think I did look at this, but I would suspect, and I’m sure I would find that if I go back and look over that 10-year period of the lost decade, that the investment did exactly what it should do. It should have tracked the S&P 500, maybe a small frictional cost to the low cost of the Vanguard fund, but it captured the return of those assets, that asset class.

And so the investment was good. It’s just that the asset class was out of favor. So, that S&P 500 as an example, as I mentioned, the difference between large stocks or small stocks or growth stocks and value stocks, those are also other examples or even US versus international. So these are all different asset classes that you could favor or not. I’m not going to get into the specifics on the investment selection, but I really think a lot of times when I get these questions, it’s not so much about the investment. It’s more about the asset class. And so that’s where I’m going to focus.

So if you’ve been listening to the Retire Smarter podcast over time, I did a four-part series on the investing process. I don’t know, Walter, maybe about a year and a half ago now or something like that. And talked through it, and everything that we do tends to be science-based. We believe in evidence, we believe in using history as a guide, and there are certain things that we tend to focus on or need to have in order to use history going forward.

I mean, on the one hand, you can just go back and look at past stock returns and do some data mining and find some cool patterns and say, “Wow, I’m going to do this.” But that doesn’t necessarily make sense. What instead we prefer is that whatever we’re looking to do, for example, say favoring small stocks over large stocks, that it’s persistent, meaning that it holds across long periods of time, different economic regimes, that it’s pervasive, it holds across countries, different regions, sectors, and even different asset classes. It’s robust, so it holds for various definitions. So for value stocks, for example, that’s another science-based factor that has shown to add value.

It’s also been out of favor more recently, as have small caps. That’s why we’re talking about this. It’s sort of coincident to this, but there are different ways to define value stocks. It could be measured by earnings. It could be measured by cash flow. It could be measured by sales. Some sort of metric like that relative to the price, but all of those different metrics do define value stocks. And so again, they’re robust. So persistent, pervasive, robust, they’re investible. It’s not just theory, but we can actually bring it into practice. And it also survives any trading costs.

So some strategies are inherently more expensive to trade. These are things, for example, like momentum strategies. And what looks good on paper gets eaten up potentially in the real world by cost. So looks on paper, but you really can’t implement it and expect any benefit after you implement it. And then lastly, certainly, we would prefer that it’s intuitive. That there’s some logical risk-based or a behavioral-based explanation for why this strategy should work and why it should continue to work overtime.

So when we think about asset classes, or even more specifically, these factors from the science-based evidence that we utilize to go ahead and build investment portfolios, those are really the criteria that we need to see over time. And again, not just some data mining thing, like, “Well, hey, this worked in 2008,” or “This worked during the tech bubble.” No, it needs to be much more than that, based on what I just discussed. So when you think about it, I’ll go back to the tech bubble again. So if you go back through the 1990s, it’s technology companies, growth companies were just going gangbusters.

You could just say, “Well, hey. Why do I want to own any of these?” Anything that is old school, maybe Warren Buffet, old economy stocks. I’m just going to go ahead and buy these growth stocks. Heck, I’m not even just going to buy growth stocks. I’m just going to buy internet stocks, things with .com, and look at my beautiful portfolio of my five internet stocks. Aren’t I incredibly well-diversified? And, of course, the answer is no.

And then, boom! You go through 2000 and the next few years, and you see that your five internet SOC portfolio maybe went down like 50% or something like that. Today, it’s a little bit different in terms of some of the underperforming investments. It’s similar. It’s certainly rhyming, but again, value stocks and small stocks had been out of favor over the last few years. And you could just maybe say, “Well, hey, forget these value stocks. Let’s just go for these growth stocks again. Let’s just go for the Apples. Let’s just go for the Amazon. Let’s go for the Microsoft. Well, heck, maybe we just buy Tesla. Well, maybe we’ll sprinkle in a little bitcoin to boot, Walter, and that’s all we need.”

Hopefully, you can tell a little bit of the absurdity in my voice in saying that, but this is what people are doing to a certain degree in bidding up these stock prices. They’re going ahead and forsaking the thing that has been underperforming and chasing these returns for things that have been bid up in price. Diversification, I think most people get to a simple degree. You don’t want to put all your eggs in one basket, so to say. The S&P 500 is really just large US stocks. It’s not a diversified mix.

One of the things that most people don’t understand is really why you want diversification. I guess, maybe more so mathematically or even in a retirement planning context. And not to get too eggheady, but there’s a concept called terminal wealth dispersion. So, yeah. Walter, let me just pause for a moment. I’ll make sure you’re still awake.

Walter Storholt:                Yeah, we need our geek alert sounder there.

Kevin Kroskey:                  Geek alert! Geek alert!

Walter Storholt:                You’re going to say that one again. Terminal wealth dispersion? Did I get that right?

Kevin Kroskey:                  Terminal wealth dispersion. So sometimes you’ll see people, and maybe they’ll own like 20 stocks or something. And there’s been articles on this in financial journals over the decades, but hey, if you own a basket of maybe like 20 or 30 stocks, if you look at it, the risk really isn’t any more than the market. And the reason why I bring that up is that it may be true from a volatility standpoint. Sometimes I’ve called this a wiggle factor. Mathematically, it’s called standard deviation. But what happens when you’re investing is a lot of the returns from the market come from a few really, really well-performing stocks.

And if you don’t own those stocks, your returns tend to really lag the market. So if you have a more concentrated portfolio, even though the volatility may be similar to what you see in more of a broad market index like the S&P 500, the dispersion of your wealth over time is much, much greater. And the reason why this matters, particularly for people that are in retirement and we’re doing retirement planning for, is you’re not measuring risk by how much of a wiggle factor your investments have.

I mean, that’s certainly something that we utilize, but that’s not the core risk that somebody has going into retirement. The core risk that somebody has going in retirement, I would say, is running out of money or not having enough money to meet your goals, whatever they are. And that really gets into that terminal wealth dispersion that I just mentioned. So if you have a concentrated portfolio or if you are casting away these underperforming assets because they’ve been out of favor and you’re just loading up on the thing that went well, you really are forsaking diversification, and you’re introducing more risk that you’re not going to meet your goals in terms of future dollars. So it’s a little eggheady, but let me pause, Walter, and bring me back down from the clouds here, buddy.

Walter Storholt:                Yeah. Terminal wealth dispersion, I’m hung up on that one. I didn’t see that phrase coming. I know our engineers are just loving this episode. This is fantastic. So, I think I’m tracking what you’re going for here, though, and I definitely am able to wrap my mind around the fact that just because an investment is performing in the positive direction doesn’t mean that it’s still not underperforming. I think that’s one good realization to certainly have, but then I think you are very poignant to point out that it’s not just about particular stocks and particular investments, that you have to look at the broader indications of the asset classes and these macro-level moves.

And also that we tend to be attracted to things as they’re doing well, so we want to hop in on bitcoin, and we want to hop in on Tesla and some of these things as they’re already up. They feel a little safer already because everyone’s talking about them, and it’s already shown that it can be a winner, and so we want to hop in on it. But are you hopping in at the tail end? Everyone else has beaten you to the punch. You’re jumping on when it feels good. They’ve benefited from before those feelings led you down that line. So I think all of that is definitely an interesting analysis, but it just seems very difficult to go against human nature in a lot of the things that you’re outlining as well.

Kevin Kroskey:                  I agree with what you’re saying. What’s interesting, though, is think about when you go shopping, and Kohl’s is a good example. If you get on their mailers, when we get the Kohl’s mailer, and there’s a 30% off coupon, we’re like, “Sweet, we’re going to Kohl’s. We got the 30%. We didn’t get the 15, we didn’t get the 20, we got the 30 this time. We’re going to get a better deal. Let’s go. We are going to like…” if you ever checked out a Kohl’s, you always save more money than you spend. I mean, what a great marketing psychological ploy that they put there. I mean, you might as well just forget the checkout, let me just go back and spend more money. I’m saving more than I’m spending.

I mean, it’s a gravy train with biscuit wheels here. But when it comes to investing, it’s the exact reverse. It’s like, people want to own the stuff that is more expensive. They don’t like the things that are cheaper. And I haven’t found another area where that’s the case, but that’s definitely how our brains work when it comes to investing. International stocks have been out of favor compared to the US for a while. So it’s like, “Why do I own these things?” The small stocks had been out of favor more recently, and quite substantially to large socks. And you look at that and say, “Yeah, they’re positive. But man, this other one, this large stock, this large growth stock, that fund is just doing fantastic. Let me sell this other thing. I’m just going to put all my money in here because it’s been doing better.”

And these are the questions that people have, and these are the things that they do in their 401(k). We don’t do this in our investing process, for sure. But after doing this for a while, I mean, they may not exactly say this in so many words like we’re saying it. But when you look at their behaviors, and you get to some of their thinking, I mean, that’s what’s often happening. But when you’re doing that, if you go back to what I talked about for that science-based evidence about what makes sense, you’re really eschewing science and just saying, “I’m just going to do this because it feels good or because it’s been doing better. So it’s probably going to keep doing better.” Your past is not prologue.

We’ve all read those disclaimers, past performance is no indication of future results, but we do it anyway. And it’s just a bad behavioral shortcut that we make rather than thinking rationally through this. And to me, it really comes down to probability in a way too. It’s process and it’s probability, and I’ll change gears here a little bit, but let’s harken back to your sportscasting days, Walter. And I’ll use a basketball example. Basketball was not my favorite sport. I made the team in high school, but it was the only sport that I sat on the bench. And so thus, I did not like it. But I have a good example, so I’m going to go into basketball. And do you remember Shane Battier?

Walter Storholt:                Oh, absolutely. Yeah.

Kevin Kroskey:                  Yeah. So he’s-

Walter Storholt:                Duke fame, right?

Kevin Kroskey:                  Yes, yeah. That’s right. It’s your neck of the woods there. Are you a Duke guy, or are you an NC guy?

Walter Storholt:                I’m a UNC grad, but my wife works at Duke, and they contribute a decent amount to the household income, so I’m a Duke fan now too.

Kevin Kroskey:                  So Shane Battier was being interviewed. It was not too long after Kobe tragically died in the helicopter crash. And Shane Battier was apparently somebody that was known to guard him I won’t say well, I don’t know if anybody guarded Kobe well, but let’s say better than most. And he’s actually in the Miami Heat’s Data Analytics Department now. And he made a comparison with blackjack and basketball, and then he talked about Kobe, and I’ll just read the quote in the article. And so Shane said, “If you’re playing blackjack, there are certain hard and fast rules. You always double down on 11, no matter what. You always split aces. You always hold on 17. Are you guaranteed 100% to win those hands if you don’t do those things? No, but mathematically, it’s proven that if you do that over a long period of time, your chances of success are greater than if you go against what you should do in those situations.”

And then he went on to talk about Kobe, and he said, “When Kobe went to his right hand and shot a shot in the paint, and you factor in the makes, the misses, the fouls, the free-throws off those fouls, the passes to the teammates and their shots off those passes, Kobe had a 62% shot. So every time he did that shot, it was worth 1.26 points, 62% times the two points. And when he went to his left hand, and I kept him out of the paint, factoring in the makes, the misses, the fouls, the free throws, the passes, the turnovers, it was only a 43% shot.” So every time he went left and did that shot, it was worth 0.84 points. Now, you don’t have to be a math major to know the guarding Kobe Bryant, you don’t want him to do the 62% thing. You want him to do the 43% thing.

And man. I read that, I’m like, “Yes, absolutely.” But if you’re dropping the underperforming asset class, you’re giving Kobe the 62% thing. You’re probably actually giving him even a higher probability. You might be stepping out of the paint and just letting him have a lay-up. The point here is, far too often, particularly in investments, that people judge decisions exclusively on the outcome, not on the process that went into the decision. Just because I’m not a blackjack guy, I’m not a card player, I’m not a gambler, but I’m about to take him for what he said here that these things make sense, but blackjack’s probability. You do those things, you’re not going to win, but it still makes sense to do them. If we’re guarding Kobe Bryant like Shane Battier, we want to push him to the left.

We don’t want them to go to the right because he’s got more probability he’s going to score. If he goes to the left, he still might. He could have a night where he gets 75% of those, and he just catches fire. Does that mean that you made a bad decision? No, just the probabilities didn’t play out in your favor that time. So it’s really process over outcomes, and it’s investing, that’s really what it is. And going ahead and abandoning an investment that is just out of favor, just because the probabilities that you put in your favor didn’t necessarily play out in terms of the outcome you were hoping is no way and no reason to go ahead and abandon what is prudent and say, “Okay, I’m just going to abandon probability. I’m just going to go ahead and follow the herd here, and I’m just going to buy Tesla and bitcoin.”

It’s not going to end well. I can’t say that definitively, but I say that with a very high degree of confidence, just understanding how markets work overtime and just seeing the absurdity that you see there. But it doesn’t have to be that absurd. It could just be like, “Hey, I don’t want to own international investments,” or “I don’t want to own small companies or value stocks,” just because they’ve been out of favor. Again, you’re forsaking probability there. You’re forsaking diversification to a large degree. You’re putting yourself at a disadvantage moving forward, and you’re really optimizing for what has worked best in the past.

You’re not going to have what happened in the past happen again. It’s not going to be likely. The future is unknowable and unpredictable, and the best that you can do is have that process to put the probabilities a little bit more in your favor.

Walter Storholt:                The difference between basketball and our investing lives however, is that basketball’s made up of individual games. So, you have to make these quick adjustments on the fly. In individual games, you take a little bit more risk to try and win that particular game because, yeah, you may only make 43% of the ones going to the left. But if that’s still good enough to beat you, then you got to change gears, you got to do something else. Maybe that night, you do force him back to the right to see if he’s having an off night. But you can’t flip flop back and forth like that in a career. If you want your career stats to be higher, or in the investing world, we don’t have to win the game. We have to win the battle. We have to win the war, right?

We have to win in the longterm. And that’s probably the big difference between those two, at least in terms of how you then react to those stats that you’re presented to that process that you’re given. So you want a long, great career. You may not win today’s game, but you can certainly win the long-term investing game by following these proven strategies and principles. And like you said, the process.

Kevin Kroskey:                  You got it. I mean, at least you’re putting the probabilities heavily in your favor if you can do that. You still don’t have guarantees. We talked about this when we talked about retirement income, and we did the four-part series on retirement income generation. There are two schools, two different ways that you can go. You can go probability-based, or you can go more of an insurance or guarantee-based. And we talked about how the guarantees are really expensive and not necessary for many people in many cases, but to have a good plan and then to be able to account for, “Hey, if the probabilities that we’re putting in our favor don’t work out that way, how does that actually affect us? How does that affect our spending goals and our lifestyle, and what have you, and how are we going to react to that?”

I mean, again, that’s the whole planning process in general. You need to start with that plan, and then just like we did in March of last year when the coronavirus really hit, and the market sold off, we stuck to the process. But the inputs were changing so quickly, the outcomes changed, and our actions changed, and it worked out well for our clients. These are things that go into it. If you look at it from a top-down view, it’s easy just to look at an investment statement and say, “Hey, this is down, and this is up. Let me own more of the thing that’s up,” or “This is up, yeah, that’s good. But this one’s really up. Let me own more of that.”

I mean, it just doesn’t make sense, and hopefully, you can see that, but mathematically, we talked about the reasoning why it doesn’t make sense. Again, it’s process, it’s not outcome. And just because you have a good process doesn’t mean that you’re going to have a good outcome each and every time. But if you do it over your whole basketball career, your whole baseball career, your whole investing career, you’re likely to have a good result over time.

Walter Storholt:                That’s a great point. If you are making decisions emotionally, it’s like starting a poker hand with two-seven. If you’re making decisions with a process, you’re ahead of the game. You’re starting with pocket jacks every time as you make your way through your investing life. I don’t know, did I stretch that one too far?

Kevin Kroskey:                  Well, right over my head, Walter. I don’t play. I’m family, work, and workout. Cards do not have anything in my schedule.

Walter Storholt:                Well, you brought up blackjack.

Kevin Kroskey:                  No, Shane Battier brought it up. I just read what he brought up.

Walter Storholt:                Oh, there you go. There you go, there you go. It’s too funny. Well, there you have it. Some good perspective on looking at some investments that are underperforming. How do you evaluate? What kind of process gets put in place to evaluate those things, to decide whether you continue holding those investments or not? It’s a big decision to make. And especially when it comes to your life savings and retirement planning, and your finances, you want to make the right choices.

And so do that with a clear head and with that process in place. Kevin, thanks for the help and the guidance on these issues on today’s show. I thought this was a great topic and I look forward to another one with you soon.

Kevin Kroskey:                  All right, appreciate it, Walter.

Walter Storholt:                Talk to you soon. That’s Kevin Kroskey here on Retire Smarter. If you’ve got any questions for Kevin, you can always reach out to him very easily by calling 855-TWDPLAN. That’s 855-893-7526 or do it the easy way, go online to TrueWealthDesign.com and click on the Are We Right For You? button to schedule your 15-minute call with an experienced advisor on the True Wealth Team. That’s TrueWealthDesign.com, and we’ll link to that in the description of today’s show. For Kevin, I’m Walter, we’ll talk to you next time on Retire Smart.

Disclaimer:                          Information provided is for informational purposes only and does not constitute investment, tax, or legal advice. Information is obtained from sources that are deemed to be reliable, but they’re accurateness and completeness cannot be guaranteed. All performance reference is historical and not an indication of future results. Benchmark indices are hypothetical and do not include any investment fees.