Why Selling Matters
Warren Buffet once said, “When we own portions of outstanding businesses with outstanding managements, our favorite holding period is forever.” This is a great quote and underlines an excellent principle of value investing. That is to keep trading down as little as possible. But it’s really not all that practical or profitable to buy and hold forever. Don’t get me wrong, holding wonderful companies with great management is our whole goal, but it’s very unlikely that one stock will be undervalued and earning great returns forever. Ultimately you’ll need to rely on value conscious decisions as to when you should sell your stocks.
After all, selling is crucial to investing success. Think of the old adage, “you make your profit when you buy, not when you sell.” This is true to a point, but ultimate return is dependent on when you buy AND when you sell. Ideally you’ll sell stocks in order to maximize gain and limit losses. However, this is often very difficult to accomplish. Most of the time we end up selling our winners too soon and our losers much too late. While locking in gains is important, limiting losses can be an even greater reason to form a systematic selling strategy. Just take a look at the graph below to see how much gain is needed to offset relative losses.
As my previous 3 articles touched on, our own emotions and psychology often prevent us from selling when we should. Fear, pride, hope (desperation), and other emotions play large roles in investor selling patterns. So knowing when and why to sell, as well as having a systematic strategy is vital.
When And Why You Should Sell A Stock
First, a few notes about the selling stocks in general. Time and time again studies have proven the more transactions you make, the more your portfolio trends toward average. But why is that? Simple, the more decisions you make, the more chances you have of making mistakes. As with buying stocks, don’t attempt to time the market or base decisions off of technical indicators. The only people who consistently buy at the bottom and sell at the top are liars. So don’t make an already difficult process even more challenging.
Let’s take a look at a few instances where you should sell a stock:
- Nearing Intrinsic Value, or Your Fair Value Range – When analyzing, valuing, and buying stocks, it’s important to estimate an intrinsic value, or a fair value range. Once share price approaches this range, consider selling the stock. That being said, don’t rely on your original range, keep your intrinsic value estimate updated every quarter or so.
- Deteriorating Fundamentals – The second instance you should sell is if you notice deteriorating fundamentals. This harks back on my previous point of reviewing your investments every quarter. In an ideal world, you would spot the deteriorating fundamentals before the stock started to tank, but even if you don’t, you should still sell.
- Analytical Mistakes – Which brings us to the third instance… an analytical mistake was made. The key to successful investing relies on analyzing data and information, not relying on your emotions. Sometimes however, the information can be misleading, or perhaps we misread it, and a mistake was made. If this is the case… move on, even if it means taking a loss. Everyone is going to make a mistake at some point or another, the only difference is some let it affect them more than others. If you’re able to learn from the error, it may ultimately be the best thing to happen to you.
- Better Opportunities – The fourth instance you should sell is if a better opportunity arises. Opportunity cost is defined as a benefit that could’ve been obtained by selecting an alternative. This is why I love metrics like free cash flow yield and earnings yield because they allow you to compare alternative investments. This doesn’t mean buy and dump stocks every week because you think you may have found a new and improved stock. Don’t fall for the grass is always greener on the other side trap. Perform your due diligence and if you find a stock that you feel can generate better results… why wait? Especially if you have a position nearing fair value or one that doesn’t seem to be working out for one reason or another.
How To Sell Stocks
Remember, successful investing includes two transactions… buying and selling. And just as you should have a clear, efficient, and systematic buying strategy, you should also have a selling one as well. The two silent assassins of buying or selling stocks are hesitation and indecision. So I like to use a process that attempts to remove emotion and offers clear-cut decisions. Let me break this approach down into 2 different categories – Gains and Losses.
Before I get into that, I want to touch on how I actually sell stocks. Not to say it’s the right way by any means, but I really enjoy using trailing stops. This type of order allows you to sell when the share price drops by a certain percentage of your choosing. I prefer to set trailing stops at 3-5% depending on the risk I’m willing to take. For example, if I own a stock that currently trades at $100, a trailing stop of 5% means the broker would automatically execute a sell order if the stock dropped to $95. The figure below represents an example of a trailing stop using an actual dollar amount. The only time I use a market order, an order that allows you to sell all of your shares at a price close to the current price, is when I want to fully exit a position immediately. This is great for cases of deteriorating fundamentals or mistakes. Let’s look at some examples.
- Once an investment nears fair value or has skyrocketed over a short period and is producing higher and higher valuation multiples, I like to initiate a 3-5% trailing stop order. The beauty of a trailing stop is it locks in gains while providing you an opportunity to not sell before more gains can be had. For instance, say a stock is trading for $100 and you’ve estimated it’s fair value to be right at $100 or maybe a little more. When you execute a trailing stop you don’t have to worry about ever selling for less than $95
- The best part, if the share price keeps rising your trailing stop simply follows along. So if the price increased to $120, the new sell point would be $114
- When our investments are steadily marching downwards, it can be a difficult time. Even when we know we should sell, as stated earlier, it’s mentally tough to overcome our emotions. In the case of mistakes or souring fundamentals I always recommend an immediate sell. However, in order to avoid emotional roadblocks and to have a systematic system, I implement a trailing stop on stocks I’m either unsure if I want to sell, or stocks I’m having a hard time letting go
- For instance, if the share price declines by 10% or more, I review the analysis and determine if I want to buy more. As long as the business is still doing well and nothing has changed, I usually purchase more of the stock. However, if there is nothing compelling me to buy more, then I initiate a 5% trailing stop on a 3rd of my total position
- In other words, if I cannot find a reason to buy after a 10% drop, then the trailing stop of 5% means I’ll sell a 3rd of my position after a 15% loss
- I then review my analysis again and if I find there was mistake or fundamentals were souring, I immediately sell. If the price decline is due to irrational movement, I may purchase more (this reduces cost basis). But if I am still undecided, then I execute another 5% trailing stop on another 3rd of my position
- Meaning I would have sold 67% of my total position after a 20% loss
- I then repeat the process once more by reviewing the investment, weighing the options, and potentially creating another 5% trailing stop and selling out at no more than a 25% loss.
- While we like to focus on researching, analyzing, and buying stocks – selling stocks is just as important in order to realize gains and minimize loss
- 4 situations in which you should sell a stock is if intrinsic value has been reached,fundamentals are deteriorating, you made a mistake, or a better opportunity exists
- Create yourself a systematic process to sell stocks in order to avoid emotional pitfalls and psychological traps
- I stick with market orders and trailing stops only, but prefer trailing stops in certain situations in order to maximize return and limit downside
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