In reviewing the performance of the Fundsmith Equity Fund (B41YBW7) for 2021, fund manager Terry Smith said the fund ‘makes money with old friends’, referring to a group of stocks in his portfolio that regularly appear in the annual list of top contributors to performance.

‘This tells you to run your winners,’ says Smith. ‘A bit like gardening, the general idea in fund management is to water the flowers and pull up the weeds, not the other way around which an awful lot of people do. They take profit on their winners and try and run their losers in the hope they will come right.’

It’s an interesting and relevant point as we see shares start to recover from the recent global market sell-off.

Nervous individuals alarmed at the value of their hard-earned money eroded by falling stock markets may now look to cash out their investments at the first sign of a rebound. This might be the wrong thing to do.

Smith’s comment that some investors are too quick to sell their best holdings and hang on to losers for too long is known as the disposition effect. It is relevant because investors are 26% more likely to realise gains in market downturns according to a new study by Sabine Bernard, Benjamin Loos and Martin Weber.

There is a saying that no-one lost money taking a profit, yet this misses this point that selling now could mean giving up even more gains down the line.

A rising share price is often a sign there is something good about the business so why sell unless you really need to spend that money?

On the flip side, investors should be more ruthless when it comes to investments that haven’t worked out. Too often we see investors hold on to laggards in the hope of their price going back up, but this doesn’t always happen.

As of 23 March, CNN’s Fear & Greed Index had gone from a reading of 19 a week earlier, classified as ‘extreme fear’, to sit at 44 which is still in ‘fear’ territory but getting close to neutral. Investor sentiment seems to be improving following recent market volatility.

The key question is whether this is just a bear market rally. These tend to start suddenly and do not last long.

There remain significant headwinds for consumers and businesses, and with oil prices trading above $115 a barrel you can be sure that inflation pains will hurt for some time.

Investors might therefore be tempted to take profit in a holding which suddenly rebounds given the fragile backdrop.

‘Investors are petrified in a bear market and try not to sell their losers. But when they see an exit sign in the form of an investment that has made a gain while the rest of the portfolio is down, they try to lock that gain in as fast as they can,’ says Joachim Klement, investment strategist at Liberum.

‘And as you might have guessed, that is again exactly the wrong thing to do, since in a bear market, the losers tend to lose even more than normal, so hanging on to them while selling your few winners is really a bad idea.’

DISCLAIMER: Daniel Coatsworth (author) and
Ian Conway (who edited this article) have personal investments in Fundsmith Equity Fund.

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