Theoretically, the ability to make money on stocks involves two key decisions: buying at the right time and selling at the right time. In order to make a profit, you have to execute both of these decisions correctly. 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. However, 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.
Many investors have trouble selling a stock, and sometimes the reason is rooted in the innate human tendency toward greed. However, there are several strategies that you can use to identify when it is (and when it isn't) a good time to sell. The most important thing about these strategies is that they attempt to take some of the human emotions out of the decision-making process.
- When it comes to investing, the decision of when to buy a stock can sometimes be easier than knowing when is the appropriate time to sell a stock.
- In general, there are three primary reasons for a long-term investor to sell: the buy was a mistake, the price has risen dramatically, or the current price is no longer supported by fundamentals.
- Emotion and human psychology can sometimes get in the way of making a smart decision, so stay attuned to the data (and not your feelings).
There are generally three good reasons to sell a stock. First, buying the stock was a mistake in the first place. Second, the stock price has risen dramatically. Finally, the stock has reached a silly and unsustainable price. While there are many other additional reasons for selling a stock, they may not be as wise of investment decisions.
When To Sell Stocks
Selling Stock Is Hard
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 more gains. 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.
In this scenario, it could be said that greed and emotion have overcome rational judgment. 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 the real question is 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. You won't even have to watch that stock go up and down. You'll get a notice when your sell order is placed.
Sell Stock When Buying Was a Mistake
Presumably, you've put some research into this stock before you bought it. You may later conclude that you've made an analytical error, and you realize the business is not 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. It's also possible that 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 immediately sell (assuming 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 a real long-term weakness in the company.
Sell Stock When the Price Rises Dramatically
It's very possible that a stock you just bought may rise dramatically in a short period of time. Many of 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. It's in your best interest to sell the stock.
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 Stock 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, suppose that Procter & Gamble (PG) is trading for 15 times earnings, while Kimberly-Clark (KMB) is trading for 13 times earnings. This is not a good reason to sell Proctor & Gamble, considering the sizable market share of many of their 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 in the late 1990s, shares of Walmart had a P/E of 60 times earnings as it opened up its first website with e-commerce. 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. It's also a good idea to 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?
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 may be seen as a positive, at least initially. This can 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.
Sell Stock for Financial Needs
This might not count as a good reason to sell a stock, but it's a reason nonetheless. Stocks are an asset, and there are times when people need to cash in on their assets.
Whether it is seed money for a new business, paying for college, or purchasing a home, this 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.