Choosing when to sell a stock can be a difficult task. It is especially difficult because, for most traders, it is hard to separate their emotions from their trades. The two human emotions that generally affect most traders with regard to selling a stock are greed and fear of regret. The ability to manage these emotions is key to becoming a successful trader. (See: Investor's Guide to Behavioral Finance)
For example, many investors don't sell when a stock has risen 10% to 20% because they don't want to miss out on more returns if the stock shoots to the moon. This is due to their greed and the hope that the stock they picked will be an even big winner. On the flip side, if the stock fell by 10% to 20%, a good majority of investors still won't sell because of their fear of regret. If they sell and the stock proceeds to rebound significantly, they'll be kicking themselves and regretting their actions.
So, when should you sell your stock? This is a fundamental question that investors constantly struggle with. You need to take the emotion out of your trading decisions. Fortunately, there are some commonly used methods that can help an investor make the process as mechanical as possible. In this article, we will look at a number of strategies to help decide when to sell your stock.
The first selling category we'll look at is called the valuation-level sell. In the valuation-level sell strategy, the investor will sell a stock once it hits a certain valuation target or range. Numerous valuation metrics can be used as the basis, but some common ones are the price-to-earnings (P/E) ratio, price-to-book (P/B) and price-to-sales (P/S). This approach is popular among value investors who buy stocks that are undervalued. It can be a good signal to sell when a stock becomes overvalued based on certain valuation metrics.
As an illustration of this method, suppose an investor holds stock in Wal-Mart that they bought when the P/E ratio was around 13 times earnings. The trader looks at the historical valuation of Wal-Mart stock and sees that the five-year average P/E is 15.8. From this, the trader could decide upon a valuation sell target of 15.8 times earnings as a fixed sell signal. So the trader has used a reasonable hypothesis to take the emotion out of his decision making. (For more on the P/E, see Profit With the Power of Price-to-Earnings.)
The next one we'll look at is called the opportunity-cost sell. In this method, the investor owns a portfolio of stocks and would sell a stock when a better opportunity presents itself. This requires constant monitoring, research and analysis on both your own portfolio and potential new stock additions. Once a better potential investment has been identified, the investor would reduce or eliminate a position in a current holding that isn't expected to do as well as the new stock on a risk-adjusted return basis.
The deteriorating-fundamental sell rule will trigger a stock sale if certain fundamentals in the company's financial statements fall below a certain level. This sell strategy is similar to the opportunity-cost sell in the sense that a stock sold using the previous strategy has likely deteriorated in some way. When basing a sell decision on deteriorating fundamentals, many traders will focus mainly on the balance sheet statement with emphasis on liquidity and coverage ratios. (Learn more about the balance sheet in Breaking Down the Balance Sheet.)
For example, suppose an investor owns the stock of a utilities company that pays a relatively high and consistent dividend. The investor is holding the stock mainly because of its relative safety and dividend yield. Furthermore, when the investor bought the stock, its debt-to-equity ratio was around 1.0, and its current ratio was around 1.4.
In this situation, a trading rule could be established so that the investor would sell the stock if the debt/equity ratio rose over 1.50, or if the current ratio ever fell below 1.0. If the company's fundamentals deteriorated to those levels – thus threatening the dividend and the safety - this strategy would signal the investor to sell the stock.
Down-From-Cost and Up-From-Cost Sell
The down-from-cost sell strategy is another rule-based method that triggers a sell based on the amount, i.e., percent, that you're willing to lose. For example, when an investor purchases a stock, he may decide that if the stock falls 10% from where he bought it, he would sell.
Similar to the down-from-cost strategy, the up-from-cost strategy will trigger a stock sale if the stock rises a certain percentage. Both the down-from-cost and up-from-cost methods are essentially a stop-loss measure that will either protect the investor's principal or lock in a specific amount of profit. The key to this approach is selecting an appropriate percentage that triggers the sell by taking into account the stock's historical volatility and the amount you would be willing to lose.
If you don't like using percentages, the target-price sell method uses a specific stock value to trigger a sell. This is one of the most widely used ways by which investors sell a stock, as seen by the popularity of the stop-loss orders with traders and investors. Common target prices used by investors are typically ones based on valuation model outputs such as the discounted cash flow model. Many traders will base target-price sells on arbitrary round numbers or support and resistance levels, but these are less sound than other fundamental based methods.
Learning to accept a loss on your investment is one of the hardest things to do in investing. Oftentimes, what makes investors successful is not just their ability to choose winning stocks, but also their ability to sell stocks at the right time. These common methods can help investors decide when to sell a stock. (For additional reading, check out To Sell or Not To Sell.)