Editor's note: We've seen some wild swings in the stock market recently...

After falling nearly 10% in December alone, the S&P 500 closed out 2018 with its worst return in a decade. But since bottoming on Christmas Eve, stocks have bounced back sharply.

If this market action worried you, you're not alone. In today's Masters Series essay, TradeSmith founder Dr. Richard Smith explains that even the world's greatest investors suffer from this problem...

Even the World's Best Investors Make This Mistake

By Dr. Richard Smith, CEO and founder, TradeSmith

For years, we've tracked the performance of the world's best investors...

Every quarter, investors who manage $100 million or more must file forms called "13Fs" with the U.S. Securities and Exchange Commission. The 13Fs show which stocks these investors bought and sold between quarters, as well as which stocks they held at the end of the most recent quarter.

By combing through these required quarterly filings, we can figure out when these investors buy and sell their various holdings. And even better, we can use this information to see how they might have fared if they were using our TradeStops tools with their portfolios.

In most cases, we've discovered that these top investors' performances could be improved – sometimes dramatically – if they had used TradeStops to manage their portfolios. In other words, using our software would help make the best investors in the world even better.

In the past, though, we only had internal data to support this conclusion. We didn't have any "outside proof" to back up our analysis. That is, until now...

You see, a group of researchers from prestigious educational institutions like the University of Chicago Booth School of Business, Carnegie Mellon University, and the Massachusetts Institute of Technology recently released a new report called, "Selling Fast and Buying Slow: Heuristics and Trading Performance of Institutional Investors." In it, they looked at the institutional "big leagues"...

They analyzed professional money managers with an average portfolio size of $573 million. They took data from 783 institutional portfolios over a 16-year period from 2000 to 2016. Overall, the researchers analyzed a total of more than 4.4 million buy and sell transactions.

And in the end, the study confirmed something we've believed for years... Professional investors are good at buying stocks – but they're terrible at knowing when to sell.

Let me explain...

The researchers created "counterfactual" results to test whether the professional money managers' buying or selling patterns were better than random. They did this by comparing the results of each actual transaction with a hypothetical "random" alternative transaction taken from another position that was not traded in the portfolio that day.

On average, these professional investors beat their performance benchmarks when buying stocks. That makes sense... When professional money managers are buying a stock, they tend to pay close attention and use their well-honed analytical skills. All their analysis and judgment is focused on deciding whether or not to buy a particular stock.

And some decisions to sell enhanced the investors' performances, too – those based on information from earnings reports. When professional money managers sell because of an earnings report, they are applying judgment to the stock itself. They are responding to data, not selling for some unrelated reason. And once again, they're paying more attention.

But their decisions to sell were significantly worse than random when it came to unloading stocks for another reason... They might as well have just thrown a dart or flipped a coin.

The researchers discovered that the investors didn't sell effectively in these cases because of a common "heuristic" – or mental rule of thumb. This rule of thumb has been observed in small-money investors in the past. But now we know professionals also fall into this trap...

We're talking about deciding to sell because of "extreme event" levels of price movement.

In the study, professional investors were more likely to sell a stock in a manner that would later hurt their total performances under one of these two conditions...

• Big losers: If the stock was down a lot, the investors were tempted to sell.

• Big winners: And if the stock was up a lot, investors were tempted to sell, too.

The researchers identified this phenomenon as a "U-shaped selling pattern"...

At one tip of the pattern, stocks that had fallen significantly were sold more often. And at the other tip, stocks that had risen by a large amount were sold more often. The middle part of the U-shaped pattern represented all the stocks in a normal range.

By selling at one of the tips, investors hurt their overall performance for two reasons...

With the stocks that had fallen significantly, the investors were already sitting on losses. By selling at that point, investors missed out on the gains from any stocks that rebounded.

And if a stock had risen rapidly before these investors sold, they frequently missed out on additional gains as a powerful uptrend continued to drive the share price higher. Selling a position simply because it's sitting on big gains is a terrible habit to have... You're much more likely to miss out on future upside – sometimes incredible, life-changing profits.

The researchers conducted all kinds of analysis on this extreme-event, U-shaped selling pattern and the ways that it hurt these professional investors' overall performances...

They confirmed that the pattern persisted across all kinds of buckets and time frames. Plus, the more aggressively money managers displayed the pattern, the worse their performances tended to be. And the money managers generally fell into the pattern more often during tough market periods, demonstrating a tendency to rely too much on rule of thumb under stress. (The greater the stress, the more tempting it becomes to just "go with your gut.")

From this study, we can learn several important lessons...

First, it proves that not even money managers with multimillion-dollar portfolios are invincible. We now have proof that even the biggest Wall Street pros – the ones responsible for hundreds of millions of dollars – make the same kinds of mistakes as small investors.

Second, it puts a serious dent in the "efficient-market hypothesis" – the theory that asset prices fully reflect all available information. If these market professionals show irrational tendencies just like the rest of us, it is impossible for markets to be "perfect" at any time. In other words, the idea of the perfectly rational investment professional is just a myth.

Third, it's tempting to fall into the trap of the extreme-event, U-shaped selling pattern – kicking out of positions just because they are up or down a lot at a given time. But as you've seen, doing that can damage overall performance for even the best investors.

That's a big reason why we encourage everyone to use our TradeStops tools...

Our tools can directly safeguard against this harmful tendency by helping investors remain detached and rational when they're deciding whether to sell. They allow you to take the emotion out of investing, so you won't ever have to deal with these difficult decisions.

And as a result, you'll become much more successful as an investor.

Regards,

Dr. Richard Smith

Editor's note: It's anyone's guess as to where stocks are headed from here. That's why Richard is joining forces with some of the world's most famous "bulls" and "bears" for a special event on Wednesday, February 13. They'll address the major questions facing investors today and tell you what things you should consider before making any investment decisions. Save your spot for this free event right here.