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2011-10-21 09:18:29
Your stock is losing value. You want to sell, but you can't bear to think of
selling now before further losses or later when losses may or may not be
larger. All you know is that you want to offload your holdings and preserve
your capital and to reinvest the money in a more profitable security. In a
perfect world, you'd always achieve this aim and sell at the right time.
Unfortunately, it isn't that easy in real life. Let's take a look at why
selling is important and then talk about a selling strategy that works for any
type of investor.
The Breakeven Fallacy
When the dotcom bubble burst in the spring of 2000 and the market started its
descent into a bear market, investors froze like deer caught in oncoming
headlights. Many didn't even react until the value of their portfolio holdings
had declined by as much as 50-60%. (For further reading, see When Fear And
Greed Take Over and Basic Investment Objectives.)
There is absolutely no guarantee that a stock will ever come back. In fact,
waiting to break even - the point at which profit equals losses - can seriously
erode your returns. To demonstrate the importance of cutting losses, the chart
below shows the amount a portfolio or security must rise after a drop just to
get back to even.
Percentage Loss Percent Rise To Breakeven
10% 11%
15% 18%
20% 25%
25% 33%
30% 43%
35% 54%
40% 67%
45% 82%
50% 100%
A stock that declines 50% must increase 100% to break even! Think about it in
dollar terms: a stock that drops 50% from $10 to $5 ($5/$10 = 50%) must rise by
$5, or 100% ($5/$5 = 100%), just to return to the original $10 purchase price.
Many investors forget about simple mathematics and take in losses that are
greater than they realize. They falsely believe that if a stock drops 20%, it
will simply have to rise by that same percentage to break even.
This isn't to say that rebounds never happen. Sometimes a stock has been
unfairly pummeled (see Forces That Move Stock Prices). But the long turnaround
waiting period (about three to five years) also means the stock is tying up
money that could be put to work in a different stock with much better
potential. Always think in terms of future potential - you can't do anything
about the past, so stop clinging to it! (See Ten Tips For The Successful
Long-Term Investor.)
The Best Offense Is a Good Defense
Championship teams have one thing in common - a good defense. This principle
can be applied to the stock market as well. You can't win unless you have a
predetermined defense strategy to prevent excessive losses. We say
"predetermined" because either before or at the time of purchase is the time
when you can think most clearly about why you would want to sell. You have no
emotional attachment before you buy anything, so a rational decision is likely
(see The Importance Of A Profit/Loss Plan). Once we own something, we tend to
let emotions such as greed or fear get in the way of good judgment.
An Adaptable Selling Strategy
The classic axiom of investing in stocks is to look for quality companies at
the right price. Following this principle makes it easy to understand why there
are no simple rules for selling and buying - it rarely comes down to something
as easy as a change in price. Investors must also consider the characteristics
of the company itself. There are also many different types of investors, such
as value or growth on the fundamental analysis side.
A selling strategy that's successful for one person might not work for somebody
else. Think about a short-term trader who sets a stop-loss order for a decline
of 3%; this is a good strategy to reduce any big losses. The stop-loss strategy
can be used by longer-term traders also, such as investors with a three- to
five-year investment time frame. However, the percentage decline would be much
higher, such as 15%, than that used by short-term traders. On the other hand,
this stop-loss strategy becomes less and less useful as the investment time
frame is extended.
If you're thinking about selling, ask yourself these questions:
1. Why did you buy the stock?
2. What changed?
3. Does that change affect your reasons for investing in the company?
This approach requires you to know something about your investing style. If you
bought a stock because your uncle Bob said it would soar, you'll have trouble
making the best decision for you. If, however, you've put some thought into
your investment, this framework will help. The first question will be an easy
one. Did you buy a company because it had a solid balance sheet? Were they
developing a new technology that would one day take the market by storm?
Whatever the reason was, it leads to the second question. Has the reason you
bought the company changed? If a stock has gone down in price, there is usually
a reason for it. Does the quality you originally liked in the company still
exist, or has the company changed? It is important to not limit your research
to only the original purchase reasons. Review all of the latest headlines
related to that firm as well as its Securities & Exchange Commission filings
for any events which could potentially diminish the reasons behind the
investment. If after some research you see the same qualities as before, keep
the stock.
If you have determined that there has been a change, then proceed to the third
question: is the change material enough that you would not buy the company
again? For example, does it alter the company's business model? If so, it is
better for you to offload the position in the company, as its business plan has
greatly diverged from the reasons behind your original investment. Remember not
to get emotionally attached to companies, and making smart sell positions will
become easier and easier.
A Value Investor's Approach
Let's demonstrate how a value investor would use this approach. Simply put,
value investing is buying high-quality companies at a discount. The strategy
requires extensive research into a company's fundamentals. (For further
reading, see the chapter on value investing in our tutorial Guide To
Stock-Picking Strategies.)
1. Why did you buy the stock?
Let's say our value investor only buys companies with a P/E ratio in the bottom
10% of the equity market, with earnings growth of 10% per year.
2. What changed?
Say the stock declines in price by 20%. Most investors would wince at seeing
this much of their hard-earned dough evaporate into thin air. The value
investor, however, doesn't sell simply because of a drop in price, but because
of a fundamental change in the characteristics that made the stock attractive.
The value investor knows that it takes research to determine if a low P/E and
high earnings still exist.
3. Does that change affect your reasons for investing in the company?
After investigating how/if the company has changed, our value investor will
find that the company is experiencing one of two possible situations: it either
still has a low P/E and high earnings growth, or it no longer meets these
criteria. If the company still meets the value investing criteria, the investor
will hang on. In fact, s/he might actually purchase more stock because it is
selling at such a discount.
With any other situation, such as high P/E and low earnings growth, the
investor is likely to sell the stock, hopefully minimizing losses.
There's No Rule That Fits All
This approach can be applied by any investing style. A growth investor, for
example, would simply have different criteria in evaluating the stock. Notice
we've referred to this approach as a guideline. It requires thinking and work
on your part to ensure these guidelines maximize the effectiveness of your
investing style. All investors are different, so there is no hard-and-fast
selling rule which all investors should follow. Even with these differences, it
is vital that all investors have some sort of exit strategy. This will greatly
improve the odds that the investor will not end up holding worthless share
certificates at the end of the day.
The point here is to think critically about selling. Know what your investing
style is and then use that strategy to stay disciplined, keeping your emotions
out of the market.
by Investopedia Staff
Investopedia.com believes that individuals can excel at managing their
financial affairs. As such, we strive to provide free educational content and
tools to empower individual investors, including thousands of original and
objective articles and tutorials on a wide variety of financial topics.