Why You Should Sell Top Stocks

I can be just as dumb as anybody else. -- Peter Lynch, September 2008

Peter Lynch earned near-30% annual returns running Fidelity Magellan from 1977 to 1990. He's sold millions of books, raised millions for charity, and holds the rare distinction of having a Motley Fool Global HQ conference room named after him.

But in September 2008, Peter Lynch also had the ignominious honor of holding both AIG (NYSE: AIG) and Fannie Mae (NYSE: FNM) in his personal portfolio -- as they dropped 82% and 76%, respectively, during that month alone.

Ouch.

For those of us who have spent our investing careers trying to match the great Peter Lynch … well, if you lost 80% in September, then congratulations -- you did it! If you did better than negative 80%, then you beat the great Peter Lynch.

Invest like Peter Lynch
We kid, of course, and we're in no way demeaning Lynch or his illustrious career. Rather, we're just pointing out how hard it's been to avoid a flameout lately. When the blue-chip S&P 500 has dropped some 40% over the course of a year, you know it's bad.

And when companies like Boeing (NYSE: BA) and Adobe Systems (Nasdaq: ADBE) drop more than 50% in the course of a year -- even though they're historically strong operators that appear to have little to do with the crisis on Wall Street -- you know it's rough out there for pretty much everyone.

In other words, even if you don't own AIG or Fannie, you probably own a best stock like AIG or Fannie. We sure do. Brian, for example, has ridden Whole Foods Market (Nasdaq: WFMI) from $40 to $12, while Tim has watched pump-maker Colfax sink from $20 on down to $10. Ahem.

We are not alone
And while there are many stocks that will recover from this market downturn, it's likely we're all continuing to hold hot stocks that won't. New research, from Professors Nicholas Barberis and Wei Xiong of Yale and Princeton Universities, gives a name for this tendency. We're exhibiting "realization utility."

Realization utility encourages investors to hang on to stocks that have sunk -- even when those stocks have dim futures. Here's how they explain it:

The authors consider an additional experimental condition in which the experimenter liquidates subjects' holdings and then tells them that they are free to reinvest the proceeds in any way they like. If subjects were holding on to their losing stocks because they thought that these stocks would rebound, we would expect them to re-establish their positions in these losing stocks. In fact, subjects do not re-establish these positions.

That's right. If we force-sold all of your top stocks and gave you the cash to reinvest, would you buy the stocks we had just sold? Odds are, you wouldn't.

So, why would you hold on to stocks that you don't think will recover? We'll let the good professors give it to you straight:

Subjects were refusing to sell their losers simply because it would have been painful to do so … subjects were relieved when the experimenter intervened and did it for them.

Wait a second
But aren't we the guys who pounded the table two years ago about how individual investors like us sell winners too early, missing out on life-changing multibagger gains to lock in a modest return? "Quick trigger fingers aren't rewarded," we wrote at the time.

And that's still true. But down markets like this one present an enormous long-term opportunity for investors … only so long as you're willing to do some selling.

See, when stocks are expensive, we may invest in mediocre stocks because they look cheap, while passing on superior operators because they're too expensive. Today, however, those superior operators are all down double digits at least.

Google (Nasdaq: GOOG), for example, dropped more than 50% in 2008. Dream stock Microsoft (Nasdaq: MSFT) -- given its growth, FCF-generating abilities, competitive advantages, and bulletproof balance sheet -- has a P/E in the single digits!

In other words, now is the time to upgrade your portfolio.

Why you should sell
You should always sell when you have a better place to put your money -- and today, a host of superior companies are on sale. The takeaway, then, is to recognize when realization utility may take root, take a sober view of your holdings, and take advantage of this down market to upgrade your portfolio. Ten years from now, you'll be very glad you did.

We're both looking to take advantage of current prices in foreign markets -- which have been hammered even worse than our own S&P 500. If you're short on ideas, you can try out our Motley Fool Global Gains service free for 30 days. You don't have to subscribe to anything, and you can take a whole month to check out our entire portfolio of premium stock market (including a list of our five favorite stocks for new money) and download every back issue. To learn more about this offer to try Global Gains, simply click here.

Brian Richards owns shares of Microsoft and Whole Foods Market (still). Global Gains co-advisor Tim Hanson owns Colfax. Microsoft is a Motley Fool Inside Value recommendation. Google is a Rule Breakers selection. Whole Foods is a Stock Advisor pick. The Motley Fool has a disclosure policy.