The vast majority of investment advice is geared toward buying. This should come as no surprise to investors since it's the buying of securities that begins the entire investment process. It's also the buying that generates commissions and fees for brokers.
But of course, what is bought must eventually be sold, and each trade exacts commissions and fees. In this article, we'll look at the art of selling a stock.
The Importance of Selling
Buying at the right price is vital. The ultimate return one will gain on any investment is first determined by the purchase price. In a way, one can argue that a profit or loss is made upon buying; you just don't know it until you sell. While this theory is deeply rooted in sound fundamental principles of investing, selling is also a vital link.
Indeed, while buying at the right price may ultimately determine the profit gained, selling at the right price guarantees the actual profit, if any. If you don't sell at the appropriate time, the benefits of proper buying disappear.
When To Sell Stocks
The Casino Trade: Why Selling Is So Hard
The reason why many have trouble selling is rooted in an innate human tendency to be greedy. For example, an investor purchases shares of stock at $25 a share, and tells herself that if the stock hits $30, she will sell. What happens next is all too common. The stock hits $30 and the investor decides to hold out for a couple of more points. Surely, the stock reaches $32 and greed continues to overcome rationality. She holds out for more.
Suddenly, the stock price takes a turn downward and is back at $29. The investor then tells herself that once the stock hits $30 again, she will sell it all. Unfortunately, this never happens and the stock price continues to drift lower. Succumbing to her emotions and frustrations, the investors sells at $23, below her initial buy price.
As greed and emotion overcame rational judgment in this scenario, sound investment principles were replaced by casino-like tendencies. The initial result was a loss. And while the investment loss was $2 a share, the true loss was $9 because the investor had the opportunity to sell at $32, but refused. Sometimes these types of paper losses are better ignored than agonized over, but it all comes down to the reason an investor chooses for selling or not selling. A sound selling decision that leaves some profit on the table may look more like a poor selling decision, but the process by which an investor makes their decision is critical.
Knowing when to sell is of paramount importance. From the example above, proper selling reduces the likelihood of suffering two ultimate consequences. In the first instance, proper selling helps ensure the preservation of gains. In the second instance, proper selling reduces the likelihood of incurring major losses.
To remove human nature from the equation in the future, consider using a limit order, which will automatically lock in your target price and sell once it reaches that price (excluding gap-down situations). This will prevent you from having to log into your trading account, or even looking at the stock price. You will be notified when the stock sold, and barring a gap-down situation, you will be happy with the gain.
Never Attempt to Time Markets
Before getting into reasons to sell stocks, investors should realize that timely selling does not require precise market timing. Very few, if any investors, will ever buy at the absolute bottom and sell at the absolute top. Consider it a healthy dose of luck if you do happen to do both. The most successful investors – Warren Buffett, Peter Lynch and others – did not succeed by buying at precise bottoms and selling at exact tops. Instead, they focused on buying at one price, and selling at a higher price.
Three Good Reasons to Sell a Stock
Provided that a share of stock is bought at a reasonable price, there are only a few reasons to sell it.
1. An analytical mistake was made. If upon buying shares, you later conclude that errors were committed in the analysis – errors that fundamentally affect the business as a suitable investment – then you should sell, even if it means a loss will be incurred. 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 one reason or another, move on.
Sure, the stock price can go up even after you sell, causing you to second guess yourself, but the key to successful investing is to learn from mistakes. Everyone will make them at one point or another. Learning from a mistake that costs you a 10% loss on your investment could ultimately be one of the best investments you make. As long as you learn from it, and go on to make better investment choices in the future.
Of course, not all analytical mistakes are equal. For example, if a business fails to meet short term earnings forecasts and the stock price goes down, that's not necessarily reason to sell if the soundness of the business stills remains intact. On the other hand, if you see the company losing market share to competitors that could be a sign of long-term weakness and likely a reason to sell.
2. Rapid price appreciation. It's very possible that upon buying shares, the stock price rises dramatically in a short period of time for one reason or another. The best investors are the most humble investors. Don't take such a quick rise as affirmation that you are smarter than the overall market. Indeed, one's chances of making money in the stock market over the long run increases significantly if you buy cheaply.
But a cheap stock can become an expensive stock in a very short period of time for a host of reasons, some of which are likely due to speculation by others. Take your gains and move on. Even better, should the shares decline later, you may be presented with the opportunity to buy again. If the shares continue to increase, take comfort in the old saying, "no one goes broke booking a profit."
If you own a stock that has been sliding and you haven’t been able to find a way out, then you can sell on a dead cat bounce. These upticks are temporary and usually based on external news. If you no longer see opportunity in your position, take advantage of this additional opportunity to exit.
3. The valuation is no longer justified by the price. This is the most difficult reason to sell because valuation is 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. Valuation will always carry a degree of imprecision because anything in the future is uncertain. Hence, this is why value investors rely heavily on the margin of safety concept in investing.
A good rule of thumb, although by no means mandatory, 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, just because The Procter and Gamble Company (PG) may have traded for 15 times earnings while Kimberly Clark (KMB) traded for 13 times earnings is no reason to sell PG, especially 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, Wal-Mart shares had a P/E of 60 times earnings. Despite Wal-Mart'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 possible that an industry is suffering only recently, which won’t show up in the annual numbers. That’s why it’s also important to look at the quarterly numbers. For example, the annual revenue numbers for major integrated oil and gas companies might be impressive annually, but what if energy prices have fallen in recent months?
Also, when you see a company cutting a lot of costs, it often means that company is not growing. The biggest indicator is reducing headcount, which is often the best way to cut costs. The good news for investors is that cost-cutting will be seen as a positive at the beginning, 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 prior to any subsequent plunge in value.
Selling for Personal Financial Needs
Of course, we are looking at this problem through the lens of market fundamentals rather than personal finance. 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, purchasing a home or something else, these types of selling decisions depend on a individual financial situation rather than the fundamental reasons for a stock being sold or the market itself.
The Bottom Line
In summary, any sale that results in profit is a good sale as long as the reasoning behind it is sound. When a sale results in a loss and is accompanied by an understanding of why that loss occurred, it too may be considered a good sell. Selling is bad when it is dictated by emotion instead of data and analysis.
Remember not to judge your selling by whether you are timing your exits near a top. Focus on selling for reasons dictated by rational analysis of valuations and price instead. Of course, in order to buy a stock you would need a brokerage account. If you don't already have one and would like to start trading, check out Investopedia's list of the best online stock brokers.