Making money on stocks involves just two key decisions: Buying at the right time and selling at the right time. You've got to get both of those right to make a profit. There are only three good reasons to sell:
- Buying the stock was a mistake in the first place
- The stock price has risen dramatically
- The stock has reached a silly and unsustainable price
Read on for more on all three of these good reasons to sell. But first, consider a couple of common mistakes to avoid when you're buying and selling.
The return on any investment is first determined by the purchase price. One could argue that a profit or loss is made at the moment it's purchased. The buyer just doesn't know it until it's sold.
While buying at the right price may ultimately determine the profit gained, selling at the right price guarantees the profit, if any. If you don't sell at the right time, the benefits of buying at the right time disappear.
When To Sell Stocks
Selling Stock Is Hard
Many of us have trouble selling a stock, and the reason is rooted in the innate human tendency toward greed.
Here's an all-too-common scenario: You buy shares of stock at $25 with the intention of selling it if it reaches $30. The stock hits $30 and you decide to hold out for a couple of more points. The stock reaches $32 and greed overcomes rationality. Suddenly, the stock price drops back to $29. You tell yourself to just wait until it hits $30 again. This never happens. You finally succumb to frustration and sell at a loss when it hits $23.
Greed and emotion have overcome rational judgment. You've treated the stock market like a slot machine and lost. The loss was $2 a share, but you actually might have made a profit of $7 when the stock hit its high.
These paper losses might be better ignored than agonized over, but it comes down to the investor's reason for selling or not selling.
To remove human nature from the equation in the future, consider using a limit order, which will automatically sell the stock when it reaches your target price (excluding gap-down situations).
You won't even have to watch that stock go up and down. You'll get a notice when your sell order is placed.
Never Try to Time the Markets
Timely selling does not require precise market timing. Few investors ever buy at the absolute bottom and sell at the absolute top.
Warren Buffett couldn't do it. He and other legendary stock pickers focus on buying at one price and selling at a higher price.
And that brings us to the three good reasons to sell a stock.
When Buying Was a Mistake
Presumably, you've put some research into that stock before you bought it. You may later conclude that you've made an analytical error. That error fundamentally affects the business as a suitable investment.
You should sell that stock, even if it means incurring a loss.
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 any reason, sell the stock and move on.
The stock price might go up after you sell, causing you to second guess yourself. Or a 10% loss on that investment could turn out to be the smartest investment move you ever made.
Of course, not all analytical mistakes are equal. If a business fails to meet short term earnings forecasts and the stock price goes down, don't overreact and sell if the soundness of the business remains intact. But if you see the company losing market share to competitors, it could be a sign of long-term weakness and a good reason to sell.
When the Stock Rises Dramatically
It's very possible that a stock you just bought will rise dramatically in a short period of time for one reason or another. The best investors are the most humble investors. Don't take the fast rise as an affirmation that you are smarter than the overall market. Sell it.
A cheap stock can become an expensive stock very fast for a host of reasons, including speculation by others. Take your gains and move on. Even better, if that stock drops significantly, consider buying it again. If the shares continue to increase, take comfort in the old saying, "no one goes broke booking a profit."
Sell for Valuation
This is a difficult decision, 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. The valuation will always carry a degree of imprecision because the future is uncertain. This is why value investors rely heavily on the margin of safety concept in investing.
A good rule of thumb 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, if Procter & Gamble (PG) is trading for 15 times earnings while Kimberly-Clark (KMB) is trading for 13 times earnings, it's no reason to sell PG when you consider the sizable market share of many of PG's products.
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, Walmart shares had a P/E of 60 times earnings. Despite Walmart's quality, any owner of shares should have considered selling and potential buyers should have considered looking elsewhere.
When a company's revenue declines, it’s usually a sign of reduced demand. First, look at the annual revenue numbers in order to see the big picture, but don’t rely solely on those numbers. Look at the quarterly numbers. The annual revenue numbers for a major oil and gas company might be impressive annually, but what if energy prices have fallen in recent months?
Also, when you see a company cutting costs, it often means that the company is not thriving. The biggest indicator is reducing headcount. The good news for you is that cost-cutting will be seen as a positive, initially, which will often lead to stock gains. This shouldn’t be seen as an opportunity to buy more shares, but rather as a chance to exit the position before any subsequent plunge in value.
Selling for Financial Needs
This might not count as a "good" reason from an analytical standpoint, but it's a reason nonetheless. Stocks are an asset, and there are times when people need to cash in their assets.
Whether it is seed money for a new business, paying for college, or purchasing a home, the decision depends on an individual's financial situation rather than the fundamentals of the stock.
The Bottom Line
Any sale that results in profit is a good sale, particularly if the reasoning behind it is sound. When a sale results in a loss with an understanding of why that loss occurred, it too may be considered a good sell. Selling is a poor decision only when it is dictated by emotion instead of data and analysis.