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When To Sell Stocks

2012-03-19 12:03:25

May 07 2010 | Filed Under Fundamental Analysis , Stocks

The vast majority of investment advice is geared towards buying. This should come as no surprise to investors since it's the buying of securities that begins the entire investment process. It's also the buying that generates commissions and fees for brokers. Of course what is bought must be sold, and each trade exacts commissions and fees.

The Importance of Selling

Buying at the right price is vital. The ultimate return one will gain on any investment is first determined by the buy price. In a way, one can argue that a profit or loss is made upon buying; you just don't know it until you sell. And, while this theory is deeply rooted in sound fundamental principles of investing, selling is also a vital link.

Indeed, while buying at the right price may ultimately determine the profit gained, selling at the right price guarantees the actual profit, if any. Thus, if you can't sell at the appropriate time, the benefits of proper buying disappear.

The Casino Trade

The reason why many have trouble selling is rooted in an innate human tendency to be greedy. For example, an investor purchases shares of stock at $25 a share, and tells herself that if the stock hits $30, she will sell. What happens next is all too common. The stock hits $30 and the investor decides to hold out for a couple of more points. Surely, the stock reaches $32 and greed continues overcome rationality. She holds out for more. Suddenly the stock price takes a turn downward and is back at $29. The investor then tells herself that once the stock hits $30 again, she will sell it all. Unfortunately, this never happens and the stock price continues to drift lower. Succumbing to her emotions and frustrations, the investors sells at $23, below her initial buy price. (Learn how to turn negative experiences into positive ones in Taking The Sting Out Of Investment Loss)

As greed and emotion overcame rational judgment, sound investment principles were replaced by casino-like tendencies. The initial result was a loss. And while the investment loss was $2 a share, the true loss was $7 because the investor had the opportunity to sell at $30, but refused.

So knowing when to sell is of paramount importance. From the example above, proper selling reduces the likelihood suffering two ultimate consequences. In the first instance, proper selling helps ensure the preservation of gains. In the second instance, proper selling reduces the likelihood of incurring major losses.

Never Attempt to Time Markets

Before getting into reasons to sell stocks, investors should realize that timely selling does not require precise market timing. Very few, if any investors, will ever buy at the absolute bottom and sell at the absolute top. Consider it a healthy dose of luck if you do happen to do both. The most successful investors - Warren Buffett, Peter Lynch and others - did not succeed by buying at precise bottoms and selling at exact tops. Instead, they focused on buying at one price, and selling at a higher price.

Reasons to Sell

Provided that a share of stock is bought at a reasonable price, there are only a few reasons to sell it.

An Analytical Mistake Was Made

If upon buying shares, you later conclude that errors were committed in the analysis - errors which fundamentally affect the business as a suitable investment - then you should sell even if it means a loss will be incurred. The key to successful investing is to rely on your data and analysis instead of Mr. Market's emotional mood swings. If that analysis was flawed for one reason or another, move on. Sure the stock price can go up even after you sell, causing you to second guess yourself, but the key to successful investing is to learn from mistakes. Everyone will make mistakes. Learning from a mistake that costs you a 10% loss on your investment could ultimately be one of the best investments you make - if you learn from it and go on to make better investment choices.

Of course, not all analytical mistakes are equal. For example, if a business fails to meet short term earnings forecasts and the stock price goes down, that's not necessarily reason to sell if the soundness of the business stills remains intact. On the other hand, if you see the company losing market share to competitors that could be a sign of long-term weakness and likely a reason to sell.

Rapid Price Appreciation

It's very possible that upon buying shares, the stock price, for one reason or another, rises dramatically in a short period of time. The best investors are the most humble investors. Don't take such a quick rise as affirmation that you are smarter than the overall market. Indeed, one's chances of making money in the stock market over the long run increases significantly if you buy cheaply. But a cheap stock can become an expensive stock in a very short period of time for a host of reasons, some of which are likely due to speculation by others. Take your gains and move on. Even better, should the shares decline later, you may be presented with the opportunity to buy again. If the shares continue to increase, take comfort in the old saying, "no one goes broke booking a profit."

Valuation is No Longer Justified by the Price

This is the most difficult reason to sell because valuation is part art and part science. The value of any share of stock ultimately rests on the present value of the company's future cash flows. Valuation will always carry a degree of imprecision because anything in the future is uncertain. Hence this is why value investors rely heavily on the concept of the margin of safety concept in investing. (Learn more about margin of safety in Take On Risk With A Margin of Safety)

A good rule of thumb, although by no means mandatory, is to consider selling if the company's valuation becomes significantly higher than its peers. Of course, this is a rule with many exceptions. For example, just because the Procter and Gamble Company trades for 15 times earnings while Kimberly Clark trades for 13 is no reason to sell PG, especially when you consider dominance with which PG products command.

Another more reasonable selling tool is to sell when a company's P/E ratio significantly exceeds its average P/E ratio over the past five or 10 years. For instance at the height of the Internet boom, Wal-Mart shares had a P/E of 60 times earnings. Despite Wal-Mart's quality, any owner of shares should have sold and potential buyers should have looked elsewhere.

The Bottom Line

In summary, any sale that results in a gain is a good sale. When a sale results in a loss, and is accompanied by an understanding of why that loss occurred, it too may be considered a good sell. Selling is bad when it is dictated by emotion instead of data and analysis. Remember not to judge your selling by whether or not you are selling at the top. Instead focus on selling for reasons dictated by rational reasons of valuations and price.

For related reading, take a look at Master Your Trading Mindtraps.

by Sham Gad