As an investor who loves to simply buy, hold and collect returns from my investments, I usually hate the idea of having to sell one of the stocks in my portfolio.
After all, I'd like to think that I invested in good companies that didn't ever need to be sold.
But sometimes, even stocks that have delivered years of solid returns lose their stride. Other times, a good company may become mediocre. And then there are times when you discover you chose a bomb of a stock instead of a treasure.
Meanwhile, dozens of other potentially great stocks await that could make your money grow much faster -- so why not just dump the stock that's not performing?
Because selling for the wrong reasons can be a costly mistake. It's much easier to buy a stock than to know when you should sell one.
Many investors are reactive and sell at the same time everyone else does -- when they're fearful. But your emotions aren't the best guide for making critical financial decisions. Look at how investors have reacted to stock market downturns in the past five years:
As you can see, investors often react and sell after it's too late. Other times, they hold on and keep losing money on a soured stock. That's why it's important to be proactive, watching the finances and moves of the company behind the stock you own, so then you can see the warning signs before your stock falls (or in some cases, plunges further than it has already).
While it's generally a good idea for most investors to sell sparingly, here are some emotion-free signs that it's finally time to sell a stock:
Warning Sign #1: Your stock has a shockingly high price-to-earnings ratio (P/E).
While you may have enjoyed healthy gains from a stock you've held onto for years, keep an eye on its price-to-earnings ratio (P/E), which essentially compares the company's most recent earnings to its stock price. Just as a relatively low P/E can signal that a stock is a bargain, a relatively high P/E can indicate that a stock is overpriced and ready for a plunge.
Case in point: From 1990 to the end of 1999, Microsoft's (Nasdaq: MSFT) stock skyrocketed more than 15,600%. However, its P/E showed the stock had climbed well into overpriced territory, trading at a price that was 84 times what it was earning per share. Once investors realized the stock was overvalued, many dumped the stock and Microsoft shares lost nearly two-thirds (63%) of their value during the year 2000.
Stay alert: While a high P/E doesn't always mean a stock is overvalued (growth stocks sometimes have much higher P/E ratios), you may want to investigate further if your stock has a P/E significantly higher than its industry peers' or the overall market's P/E (historically it's been between 14 and 17). You can compare a company's P/E with its peers' using the financial data website Morningstar.com -- here's how Microsoft compares today.
Warning Sign #2: The company's competitive advantage is in danger.
Whether it's through a superior product, brand power, low prices, patents or technology, a company's competitive advantage is the wall that keeps competitors from taking away market share and profits. But if competitors find a better way, a company's competitive advantage can disappear quickly, and the stock's future growth could be in jeopardy.
For example, movie-rental company Blockbuster used to beat competitors with convenience -- by having more stores, more available movies and flexible return policies. But when competitors like Netflix (Nasdaq: NFLX) offered mail-order DVD service and movies to stream online from home, Blockbuster's competitive advantage completely disappeared, the stock became worthless and the company filed for bankruptcy -- all between 2002 and 2010.
Stay alert: Study the latest headlines about your stock and look for broad changes in industry trends. Are competitors providing a better service or offering a better price? Are consumer tastes changing, and is the company you are invested in adapting to these changes better than its competitors? Is the industry as a whole growing or shrinking? No one can predict exactly what will happen as industries change, but your stock should represent a company that has a clear edge over competitors in a healthy industry -- otherwise, be prepared to sell.
Warning Sign #3: The company makes drastic changes in its direction or leadership.
You may have originally bought a stock because you felt the company had a winning business model and good management that would give you healthy returns over time. But then the company suddenly changes -- perhaps it loses its visionary leader that carried it to success (like Apple's (Nasdaq: AAPL) Steve Jobs) or maybe the company changes its business model or vision. Dramatic changes like these can dramatically alter a company's future performance.
Stay alert: Change is inevitable in almost every company, but if the business loses the leaders or business model that you felt made it successful in the first place, it's time to re-evaluate. Do you feel the company will continue to be successful? Research the new leaders and changes, follow your instincts and consider dumping the stock if you feel uncertain of the company's future.
Warning Sign #4: The company's sales are stalling or falling.
While a tough economy can make it difficult for companies to keep sales growing every year, a trend of falling revenue may signal that the company has trouble marketing or selling its products and services or finding new sources of income.
Stay alert: Watch the company's annual income statement; its top line should have been steady or growing during the past few years. If revenues are trending downward, especially in an industry where competitors have experienced sales growth over the same period, then it may be time to sell if you don't think good times are ahead for the company.
Warning Sign #5: The company's profit margins (and earnings) are shrinking.
Profit margin is simply the percentage of revenue a company takes in as profit (after expenses, taxes and interest have been paid). A trend of shrinking annual profit margins signals that the company's expenses are rising faster than its revenues -- meaning a company is having trouble keeping costs under control and keeping profits up.
Stay alert: As with revenues, look at the company's past annual income statements to see if profit margins have been holding steady and that net income (profit) has been growing in the past few years. If competitors have been able to keep their profit margins and net income growing while your company's earnings have stalled or declined, then be prepared to hit the sell button.
Warning Sign #6: The company recently cut its dividend payment.
Management will almost always put a positive spin on things to make the company's future look rosy to analysts. But a company's actions will speak louder than words. While a mature company raising its quarterly dividend payment can signal optimism about its future and can reward its shareholders with a larger dividend, a company slashing its dividend payment often is expecting lower earnings and less growth in the future.
Stay alert: If a company (assuming it pays a dividend at all) announces it will reduce the size of its dividend payments to its shareholders, then understand why the decision was made. Some companies slash their dividend payment to free up cash for research and development or expansion purposes, which is fine if you believe it's a good move (see #3 for help on that). But other times, that's not the case. If you don't want to stick around and weather the storm of weak future earnings, then a dividend cut announcement may be yet another indicator that it's time to exit.
Action to Take --> Knowing when to sell a stock is extremely difficult, even for professional investors, so look for more than one or two warning signs before you pull out. The stocks that are really worth selling likely will carry more than a few of these trouble signs, which will make your decision easier. If the stock that you hold represents a company in decline or in a declining industry and the reasons you bought the stock in the first place have changed considerably, then it may be time to cash in the chips. On the bright side, you'll have more cash free to make your next great investment.
This article originally appearead on InvestingAnswers.com:
Wondering When To Sell A Stock? Use This 4-Minute Checklist