By Paul Price
In the latest Best Game in Town, MarketShadows, March 10, 2013
All investors want to believe their superior research and intelligence will steer them towards making good trades. Well-informed buy and sell decisions form the basis for any chance at outperforming the indices.
Few of us have unlimited investable resources. That means we often have to triage our holdings when we uncover what we see as a great stock to buy. We are required to exit our least promising existing position to raise the money to fund our newly discovered gem.
While the concept of selling one stock to buy another is not rocket science, the ability to actually improve our overall results is much harder than it would intuitively seem.
Think about an NCAA tournament basketball player who shot a respectable 70% from the free-throw line throughout the entire season. Our gut instinct when he walks to the line ‘shooting two’ is that he’ll probably make both shots most of the time.
Statisticians in the crowd know better. Each shot is a separate event from a probability standpoint. Thus, the chance that he will sink both free throws is calculated as 0.7 x 0.7 = 0.49. A 70% overall success rate translates into making both ends slightly less than half the time!
When you sell one stock to buy another you’ll need to be right on more than 70% of your decisions to see a better than 50-50 chance of goosing your portfolio’s return. Why? Consider the various possibilities. The shares you sell could go up more than the newly acquired ones. Despite your optimistic viewpoint, the new holding might go down more than the one you decided to jettison. In a real worst-case scenario, the company you exited might surge higher while its replacement tanks.
Add in the frictional costs of bid-ask spreads and commissions and it’s even a little tougher than the 70% or better implied decision-making success rate I mentioned earlier to get a positive impact.
If investing was easy, we’d all be rich already.
Good luck to all in your investments as well as your NCAA and NIT brackets.