This investing quote changed my life.
Don't cut your flowers.
Disclaimer: This article is for informational and educational purposes only. Do not interpret anything below as financial advice. Always do your own research & speak to a financial professional before making investment decisions.
One of my favourite quotes in investing is from Peter Lynch's book, "One Up On Wall Street". In the book, he says: "Selling your winners and holding your losers is like cutting the flowers and watering the weeds".
When I first read the book in 2020, I probably didn't pay much attention to the quote. It was early in my investment journey (it still is!) and I now believe that it's one of those lessons each investor has to learn through experience in the markets.
Fast forward 4 years and my chances of becoming the next Peter Lynch are next to zero, however, I've learned through painful investment decisions the importance of holding on to winning stocks at all costs. I can't stress this enough.
Letting winners run is something many investors have great trouble with. Yet, as Mohnish Pabrai reminds us time again, the asymmetric nature of the investment industry makes it one of the most forgiving industries out there.
What does he mean by this?
Let's take a simple example of an investor, James, who amasses a $100,000 portfolio of 10 stocks. James allocates 10% of his capital, or $10,000, to each position. Let's assume that 9 out of the 10 stocks in the portfolio turn out to be terrible investments and go to zero.
The remaining stock, however, turns out to be a "10 bagger". A 10 bagger, in Lynch talk, refers to stocks that 10x in value within a given time frame. Despite 9 stocks going to zero, James manages to recoup all of his losses by holding on to a 10 bagger stock that grows his $10,000 to $100,000.
Feeling satisfied about clawing back his losses, James decides to sell out of the position to focus on other projects. A few years later, he checks his investment account and is surprised to see that he would be sitting on $300,000 had he simply held on to the position he exited. The stock went up 30x since his initial investment!
This simple story demonstrates the forgiving nature of the investment industry. The most you can lose on an investment is always 100%. There is no limit to the upside potential, with James' winning stock returning 1000% and recouping the losses from the other 9 positions.
The story also shows the importance of letting winners run and not cutting the flowers. All it takes is a wonderful investment to change one's fortunes dramatically, regardless of many lousy investments. Had James' not sold and remained patient, he'd be sitting on a 30x return with 3x more than what he started with.
But what is the likelihood of finding such multibaggers?
Well, it turns out that during his tenure at Magellan, Lynch scooped up more than one hundred 10 bagger stocks. With this in mind, surely the average investor can find a few of these elusive gems over a lifetime.
I recently completed an exercise whereby I analysed all the stocks I have sold during my investment journey since 2020 across several portfolios to see which of the stocks I sold went on to become multibaggers.
The results are astonishing…
1) Meta Platforms Inc ($META)
Avg. purchase price: $167
Sell price: $295
Current price: $468
I missed out on a three bagger by selling too early despite almost doubling my initial investment.
2) UFP Industries ($UFPI)
Avg. purchase price: $37
Sell price: $50
Current price: $119
I sold for a 1.3x return. Had I held, I'd currently be sitting on a 3.2x return.
3) Zebra Technologies ($ZBRA)
Avg. purchase price: $168
Sell price: $166
Current price: $254
I sold for a small loss, missing out on a 1.5x return. Interestingly, this stock reached $607 in 2021, 3.6x more than my av. purchase price.
4) Dicks Sporting Goods ($DKS)
Avg. purchase price: $96
Sell price: $115
Current price: $162
I sold for a 1.1x return. Had I just held, I'd have almost doubled my initial investment.
Now, clearly none of the returns above compare to the 10x and 30x examples described previously. Selling these stocks too early, however, can be considered errors of commission especially as these stocks continue to compound in value.
In investing, errors of commission typically refer to actions taken that result in a loss or suboptimal outcome. In this case, selling an investment too early could be seen as an error of commission because I actively made a decision to sell, which resulted in potentially missing out on further gains.
On the other hand, a mistake of omission typically refers to actions not taken that could have resulted in a better outcome. An example of a mistake of omission in this context would be failing to sell an investment that is declining in value and subsequently suffering larger losses.
In his book "What I Learned About Investing From Darwin", Pulak Prasad goes into greater detail about these two error types and explains how in investing, success rates skyrocket if investors focus on reducing the rate of type I errors (errors of commission) rather than type II errors (errors of omission).
His example demonstrates how investors who become better at rejecting bad investments (i.e. reducing type I errors) improve performance by 16% by simply reducing their error rate from 20% to 10%. Conversely, investors who focus on not missing out on good opportunities (i.e. reducing the rate of type II errors) improve performance by a measly 3% by reducing the error rate by the same amount.
In simple terms, investors should focus on reducing actions that result in suboptimal outcomes rather than focusing on actions not taken that could have resulted in better outcomes.
Selling out of an investment too early is generally considered a mistake of commission because it involves an active decision that may have negative consequences in terms of missed opportunities for greater returns.
Let your winners run. Don't cut the flowers to water the weeds.