One behavioural quirk that almost every investor has experienced at some point is a deep reluctance to crystallise a loss. We all know it's a big mistake, and yet we all make it. We take a look at the psychology behind what's been named the "disposition effect" in the box below. But the key point is that it's painful, whoever you are and however canny an investor you are, to sell shares when it means acknowledging that you have taken a hit as a result. None of us makes the decision comfortably, and many of us put it off until we feel we have no other choice.
So what does it say about a company if its directors who should be in a position to know the company better than anyone else are willing to sell at a loss? That's the question raised in a recent paper by Peter Kelly of the University of Notre Dame, highlighted by John Authers on Bloomberg. Investors often pay attention to director dealings, but the usefulness of doing so has always been a little vague.
Just because a director or founder is selling, for example, doesn't mean that anything sinister is going on things like divorce or school fees or simply locking in some hard-earnedgains are perfectly valid reasons for insiders to offload some of their shares. As a result, a straightforward "sell" decision by a director doesn't mean you should follow suit.
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Yet as Kelly notes, if directors are selling at a loss, it should be a far more sinister sign for investors in the stock in question. "Since selling at a loss is painful, an investor who does so must have particularly negative information, information that manifests itself in a poor stock return over the next few months." And it turns out that Kelly's hunch is correct such stocks underperform the wider market in the wake of the sale. In short, "a sale of stock at a loss is a much more negative signal about future returns than a sale of stock at a gain". Kelly also found that if more than one insider takes a loss on a share sale, or the loss taken is particularly large, then the subsequent return of the stock is even worse.
The tricky part, as Authers notes, is figuring out at the point of sale whether or not a director has taken a loss. However, if you aremaking the effort to invest in individual stocks, then it shouldn't be too hard for you to record when directors buy and at what price, then monitor any "sell" decisions closely. Kelly found that the most recent purchase price worked well as a reference price in his research. Be particularly watchful of companies already showing signs of stress any loss-making director sales in this case suggest a recovery is not imminent. In short, if an insider is willing to swallow their pride and lose money, they must have good reason and history suggests you should do the same.
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