|When it comes to buying a stock, there's no shortage of advice, both useful and otherwise. Virtually every investment magazine, newsletter, or financial news program offers tips, opinions, analysis, and a variety of hot stocks you should buy immediately. But when it comes to the sell decision, there is little useful advice to be found. |
Buy and hold has been the prevailing strategy for the small investor and this has worked well in recent years — in a forgiving market. But the tenor of the stock market has changed since March 2000, when equities started heading south. A successful investor now has to pay much closer attention to stock performance and, more often than not, wrestle with that painful sell decision.
So what do you do? Maybe you have stocks that have done well. Is it time to lock in profit? Other stocks are down. Is this just a temporary slump? Will they come back? Can you afford to sit and wait?
As you struggle with the sell versus hold decision, be aware of common traps such as emotional attachment and the reluctance to take a loss. These traps will lead you to hold onto stocks long after they should be sold. You may love a stock and feel it was your most brilliant investment; or if a stock is down, you may be reluctant to take a loss. After all, you say, it's only a paper loss until you sell, and if you wait long enough, maybe the stock will go back up.
Another trap some investors fall into when the price is down is to choose a less painful alternative to selling by doubling up on the shares. This reduces the average purchase cost, and if the stock ever comes up, they will make even more money. But will it ever come up? Be careful not to fool yourself. You need to know when the time has come to sell a stock.
HOW DO YOU KNOW WHEN TO SELL?
Here are some selling rules commonly used by small investors:
1 Sell when the stock reaches a target price. When you first buy a stock, it is important to estimate its future price. Some investors set a goal such as a 30% price increase. Benjamin Graham, Warren Buffett's mentor, considered selling a stock when the price moved up 50%. Reaching a goal should cause you to evaluate the situation. But an arbitrary decision to sell based solely on reaching a target price can cut you out of future profits. Why did the stock go up? Will it continue to rise? What factors have changed? Don't forget, you will have to find an equal or better place to put the proceeds once you do sell.
Keep in mind that when you sell you should be concerned with the future course of the stock, not the past. In addition, if you sell only winners you will end up holding only the dogs. Automatic sell decisions, however, are great for brokerage commissions.
2 Sell on initial bad news about the company. True, more bad news often follows and bad news should cause you to reevaluate the situation. But never make a sell decision based on a single factor.
3 Sell when the overall market looks bad. Market pessimism usually develops too late in the game to be of much help. As a rule, the time to be worried is when analysts, brokers, and investors are universally optimistic. The danger is that when everyone is optimistic about the market they tend to become fully invested so there is no money left to purchase stock. When price levels cannot be maintained, the market falls. When people are pessimistic, on the other hand, there is still money around to buy stock.
4 Sell all or part of a holding in order to balance a portfolio. This is generally a good idea, as it is important to maintain a well-diversified portfolio. One rule of thumb is no stock should account for more than 20% of the value of a portfolio under $100,000 or more than 10% of the value of a portfolio over $100,000.
5 Sell when the stock takes a downturn after a steady gain. Every stock has ups and downs. If you sell after an initial downturn you could miss future profits. Maintaining an investment horizon of four or five years will reduce the impulse to sell at the first setback.
6 Sell if the stock price trend isn't good. Your stock has hit a high, dropped back, then made two or three unsuccessful attempts to regain that high. With each attempt the price has peaked a little lower. This could lead to a legitimate sell decision. Don't make the decision based on this one factor; it should be included in a comprehensive analysis. Charting the stock price can help you see what's happening.
7 Sell if earnings are restated.
It's time to consider selling. Restated earnings suggest management doesn't know what is going on.
8 Sell when an earnings estimate is missed. What caused the earnings problem? Is it a one-time occurrence or are the financials deteriorating? This can forecast a downturn. It's time to consider selling.
9 Sell because of changes in the industry. This is always a judgment call; if you can spot a change early enough, it can provide you with a timely signal to get out.
10 Sell when management appears to be incompetent. There have been recent instances, particularly since the economy turned, where corporate management made ill-considered decisions that seriously hurt the company. This is a sell signal.
11 Sell based on a tip. As in buying a stock, a tip may provide a lead that after careful analysis produces a good candidate for your portfolio. But don't ever buy or sell based on a tip alone (even if your brother-in-law, who works in shipping and receiving, knows a lot about the company).
HOW TO MAKE THAT SELL DECISION
A successful private investor should continually review each holding. This takes time and it's cumbersome, but it pays off. Look for changes in the factors that originally made you decide to buy the stock. A sell decision is really the reverse of a buy decision. When you originally bought a stock, you employed a variety of yardsticks in your evaluation. Perhaps you looked at earnings growth, sales trends, cash flow, price to earning growth (PEG), the health of the industry, the company's product line and placement, and the quality of management. There is an endless list of evaluation criteria and you probably had good reasons for making your original buy decision. Do these reasons still exist? What has changed?
And finally, the big question — Would you buy the stock again at today's price? If not, then consider liquidating it.
If the fundamental reasons behind your investment are still intact, hold onto the stock. If enough of those reasons have changed, sell. That's the way to create wealth over the long term.
Michael Patterson is a former management professor, business school dean, and college vice president. He has written a variety of articles on business and management.
Current and past articles from Working Money, The Investors' Magazine, can be found at Working-Money.com.